Stalla Question on Real Exchange Rate

investing, exchange, between, current

I really don’t get their explanation on this with lots of symbols and stuff (please show your work so I know what’s going on):
John Smith is a U.S. Bond portfolio manager. John is considering investing in a portfolio of Canadian dollar-denominated bonds. The current nominal spot exchange rate between the U.S. and Canada is 0.65 USD/CAD. The price level of the typical consumption basket in the U.S. to the price level of the typical consumption basket in Canada is 0.65 to 1.
A year later the inflation rates have indeed been 5 percent for U.S. and 3 percent for Canada. However, the Canadian dollar has depreciated with an exchange rate of 0.61 USD/CAD at the end of year one. Assuming the real exchange rate is 1 at the beginning of the year, the real exchange rate at the end of the year is approximately:
A. 0.96 USD/CAD
B. 0.94 USD/CAD
C. 0.92 USD/CAD

KungFuPanda

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发表于 2013-4-17 17:37 | 只看该作者

Real start = 0.65 USD/CAD * 1/0.65 PCAD/PUSD = 1$/CAD
1 year later:
0.61 USD/CAD * 1/0.65 PCAD/PUSD * 1.03/1.05 (Inflation)
= 0.92 USD/CAD
Basket of goods changes price due to inflation.

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pacmandefense

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发表于 2013-4-17 17:37 | 只看该作者

i have a little question here, according to purchase power parity,
S1 = S0 x inflation_foreign / inflation_domestic
then should we multiply the real rate with 1.03/1.05 instead? (US is foreign and Canada is domestic?). It also seems to make sense cuz inflation in the U.S is higher than that of Canada, so USD should depreciate against CAD, right?

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Sunshine4ever

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发表于 2013-4-17 17:37 | 只看该作者

please read the real-exchange rate stuff in the International asset pricing (Portfolio Mgmt) chapter. This question is solved there in great detail.
0.65 USD / CAD with a basket of 0.65 PUSD/PCAD
So Real rate = 1 USD/CAD today.
Price Basket 1 year later = 1.03/(1.05 * 0.65)
So now adjust the 0.61 USD/CAD 1 year later back at the basket rate then.

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pawn