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Carole Holden, CFA, is an economist for the International Monetary Fund. As a believer of purchasing power parity (PPP), she wants to create a suitable basket of goods for use in all countries as a means of determining exchange rates. Although she is very idealistic in her endeavor, one major shortcoming in her approach is that absolute PPP assumes:

A) real interest rates are constant throughout the world.

B) there are no restraints to trade.

C) inflation rates are constant throughout the world.

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Absolute PPP is of little use in determining exchange rates. In order to directly compare the prices of goods and services between two countries, identical individual goods and services are necessary to establish the validity of the law of one price. However, goods are rarely identical between various countries. In reality, restraints to trade, including differences in taxes, transportation and labor costs, rents, and government controls (e.g., tariffs) provide complexities that prevent direct comparison. Therefore, it is difficult (if not impossible) to confirm whether exchange rates are under- or overvalued according to absolute PPP.

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Willie Muller is a senior loan officer with a money center bank in New York. He has many multinational clients, including several who do a large percentage of their business with customers in Germany. Recent political developments in Europe have led to uncertainty regarding future exchange rates. The risk management team at Muller’s bank is concerned about the potential impact that increased volatility in exchange rates may have on his clients’ operations. The bank’s loans are denominated in U.S. dollars; however, these particular clients conduct their operations primarily in Euros. Since the clients bear the exchange rate risk, Muller and his risk management team are concerned about their clients’ exposure and the implications to the bank. Any negative impact to earnings could ultimately impair the ability of his clients to repay their outstanding loans. Muller has been asked to assess the bank’s exposure to Muller’s customers under a variety of economic scenarios.

In order to better understand his clients’ foreign exchange risk, Muller undertakes a review of the factors that underlie exchange rates including the principle of purchasing power parity (PPP). To do so, he must factor in the interrelationships between exchange rates, interest rates, and inflation rates. Also of importance are growth projections for the German economy, and how these might be affected by government policy. Muller begins to gather information that he believes may be useful in his analysis. He discovers that over the past two years, the price level in the U.S. has increased from 100 to 112 while the price level in Germany has increased from 100 to 104. Also, he notes that the current $/