Given
Thailand Great Britain Predicted annual inflation rate for next 5 years 3.4% 1.9% Current exchange rate: THB/GBP, i.e., THB per GBP 51.4801
To find the exchange rate in 5 years, i use:
3.4 - 1.9 = 1.5%
(1+0.015)*51.4801 = 52.2523
this calculation is wrong. Even the section “4.6.9.1. Purchasing Power Parity” uses this calculation.
The CFA answer is :
( 1 +((1+0.034)^5 - 1) - ((1 + 0.019)^5 - 1) )*51.4801 = 55.7674
which is weird.
This is formula for covered IRP SpotA/SpotB
Forward rate A/B = Spot A/B * (1+IRA) ^ n/365 / (1+IRB) ^ n/365. Since 5 years horizon calculation was required, the formula used is OK. I suggest use always covered IRP formula. You can use inflation rates instead IR rates.
The issue here is the question specifically ask to use PPP, but the answer shown is not calculated using PPP.
The question is from Exeter Asset Management case.
The CFA answer is correct
Predicted annual inflation rate for next 5 years Thailand,3.4% Great Britain, 1.9%
The inflation rate need to be compounded for next 5 years ie (1+0.034)^5 & (1+0.019)^5. Even illustration in section “4.6.9.1. Purchasing Power Parity” is showing the same, compounded inflation
ah, understand it now. thank you.
this question got me also and section 4.6.9.1 tells us to use difference in inflation not the formula given in exam the answer. my feeling is that this question was copied out of an old curriculum book and is not good practice from the institute.
oh well.