Stalla Question on Real Exchange Rate investing, exchange, between, current

lucasg85

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

jbaldyga

ahhh? right?? it’s in real rates? thank you guys? one more area covered…………..thx

pawn

With real reates, Currency Y is on top of Currency X, or should I say price baskets.

Sunshine4ever

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.

pacmandefense

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?

KungFuPanda

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.