please help me understand why option B is correct instead of option C. why purchasing power is not affected in statement 2 of Example 1 as given below.
Example 1
Nominal and Real Exchange Rates
An investment adviser located in Sydney, Australia, is meeting with a local client who is looking to diversify her domestic bond portfolio by adding investments in fixed-rate, long-term bonds denominated in the Hong Kong dollar. The client frequently visits Hong Kong SAR, and many of her annual expenses are denominated in the Hong Kong dollar. The client, however, is concerned about the foreign currency risks of offshore investments and whether the investment return on her Hong Kong-dollar-denominated investments will maintain her purchasing power—both domestically (i.e., for her Australian-dollar-denominated expenses) and for her foreign trips (i.e., Hong Kong-dollar-denominated expenses for her visits to Hong Kong SAR). The investment adviser explains the effect of changes in nominal and real exchange rates to the client and illustrates this explanation by making the following statements:
To demonstrate the effects of the changes in inflation and nominal exchange rates on relative purchasing power, the adviser uses the following scenario:
“Suppose that the AUD/HKD exchange rate increases by 5 percent, the price of goods and services in Hong Kong SAR goes up by 5 percent, and the price of Australian goods and services goes up by 2 percent.”
Statement 2
All else equal, an increase in the nominal AUD/HKD exchange rate means that your relative purchasing power for your Hong Kong SAR trips will increase (based on paying for your trip with the income from your Hong Kong-dollar-denominated bonds).
A. correct.
B. incorrect, because purchasing power is not affected in this case.
C. incorrect, because based on the quote convention, the client’s relative purchasing power would be decreasing.
Solution:
B is correct. When paying for Hong Kong-dollar-denominated expenses with Hong Kong-dollar-denominated income, the value of the AUD/HKD spot exchange rate (or any other spot exchange rate) would not be relevant. In fact, this is a basic principle of currency risk management: reducing FX risk exposures by denominating assets and liabilities (or income and expenses) in the same currency.