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LOS h: Calculate the end-of-period exchange rate implied by purchasing power parity, given the beginning-of-period exchange rate and the inflation rates.

Kathy Smith, CFA, is an analyst with the Borderless Fund and is doing research on the country of Kenya for her colleague, John Dolan. Smith wants to calculate the inflation rate implied in the forward rates that she obtains from her bank, Global Bank. The current spot exchange rate is 90.772 Kenyan Shillings (KS) for one euro (EUR). The one-year forward rate for the Kenyan Shilling is 95.7686 KS/EUR. The current rate of inflation the European Economic Community is 9%. Smith does not know the current inflation rate for Kenya. Assuming relative purchasing power parity (PPP) applies, the calculated expected inflation rate implied in the forward rate is:

Solve for the expected inflation rate for Kenya implied in the forward rate (i_K) by using the same formula for relative PPP:

S₁ = S₀ × [(1 + i_FC) / (1 + i_DC)]
S₁ = KS95.7686 = KS90.772 × [(1 + i_K) / (1 + 0.09)]
i_K = 15%

Brian Kenny, CFA, is an economist for Borderless Fund and was instructed by his colleague, John Dolan to create a forecasted exchange rate at the end of two years, Kenny’s investment horizon for the country of Kenya. The current spot exchange rate is 90.772 Kenyan Shillings (KS) for one euro (EUR). Kenny calculates annual inflation rates of 13% for the next two years for Kenya and 11% for the Economic European Community. Assuming relative purchasing power parity (PPP) holds, the expected spot exchange rate at the end of two years is:

The KS is the foreign currency and the EUR is the domestic currency because the spot quote is KS/EUR:

S₁ = S₀ × [(1 + i_FC)² / (1 + i_DC )²]
S₁ = 90.772 × [(1 + 0.13)² / (1 + 0.11)²] = 94.0725 KS/EUR

The KS is expected to depreciate against the EUR over the next two years.

John Dolan, CFA, is an international fund manager with the Borderless Fund. Dolan is considering an investment in the country of Kenya. He is concerned with the inflationary environment in Kenya, but he feels that it is mitigated by the degree of high economic growth over the next year. Based on his research, Dolan found that Kenya is expecting inflation rates of 17% while the European Economic Community is expecting 9%. The current exchange rate is 90.772 Kenyan Shillings (KS) per euro (EUR). Dolan assumes that relative purchasing power parity applies. If Dolan wants to compute an exchange rate at the end of the year so that he can use it for purposes of portfolio valuation, the closest exchange rate (KS/EUR) would be:

The KS is the foreign currency and the EUR is the domestic currency because the spot quote is KS/EUR:

S₁ = S₀ × [(1 + i_FC) / (1 + i_DC)]
S₁ = KS90.772 × [(1 + 0.17) / (1 + 0.09)] = 97.4342 KS/EUR

The Kenyan Shilling is expected to depreciate against the euro over the next year.