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Extract: The question stated that the current spot rate was dinar 150 – 175/$. As Penn Co needs to sell $s initially, the bid rate of dinar 150/$ will apply. As all other cash flows are receipts in dinars, a working is needed to compute the projected offer spot rates via the purchasing power parity theory (PPPT) formula.
Question: Please help explain, why 175 is used to calculate future spot rates. Shouldn’t we be using 150?
Thanks in advacne!
No. The future flows are receipts of dinars and therefore they will be selling dinars and buying dollars, and the rate for selling dinars at the moment is 175 (but this is the current spot rate and will change in the future). (If they were to convert the receipts at 150 it would mean that the would receive more dollars and this cannot be the case – it is always the rate that is worse for the company because it is the banks who make the profit 🙂 )
It will help you to watch the first of my free lectures on foreign exchange risk management, because in this lecture I explain how to decide which exchange rate to use.
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