The rate of inflation in India is 8% per annum and in the U.S.A. it is 4%. The current spot rate for USD in India is Rs. 46. What will be the expected rate after 1 year and after 4 years applying the Purchasing Power Parity Theory.
Solution
According to Purchasing Power Parity theory
F/S = 1+iA/ 1+iB
Where F = Forward Rate
S = Spot Rate
iA = Rs. inflation Rate and
iB = $ Inflation Rate
After 1 Year
F/46 = 1+0.08/ 1+0.04 therefore F = Rs. 47.769
After 4 Years
F = 46 x 1.08/1.04 x 1.08/1.04 x 1.08/1.04 x 1.08/1.04 = Rs.53.4958
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