Assume that the basket of goods and services consumed by a typical household costs 100 pounds (£) in the UK and 8,000 rupees (₹) in India. The market exchange rate between the pound and the rupee is ????₹/£=101.33. Would the pound be considered overvalued or undervalued relative to the rupee by Purchasing Power Parity standard?

 

 Mary is the global sourcing manager for a UK retailer. She has just signed a deal to import wine from a French vineyard. The contract is invoiced in euros, and the payment of 800,000 euros is due in six months. The six-month interest rate is 4.45% per annum in the UK and 2.95% per annum in the Eurozone. The spot and forward exchange rates between the pound sterling and the euro are as follows:

 

                                                              Bid             Ask

Spot rate (euros per pound)         1.1402       1.1408

Forward rate (euros per pound)

One month                                       1.1372      1.1378

Three months                                  1.1346       1.1352

Six months                                         1.1309     1.1315

Twelve months                                 1.1244         1.1251

 

(i) Given the interest rate and exchange rate quotations above, describe two ways Mary can hedge her transaction exposure arising from the wine import contract. Assume that there is no other transaction cost for trading currencies, borrowing or lending in the UK and Eurozone. Which hedging alternative is superior? Explain why.

(ii) If the exchange rates and euro interest rate stay unchanged, what sterling interest rate would make Mary indifferent between the two alternative hedges?

Answer rating: 100% (QA)

SOLUTION To determine whether the pound is overvalued or undervalued relative to the rupee by Purchasing Power Parity PPP standard we can compare the relative prices of the basket of goods and service... View the full answer