You are the treasurer of a U.S. multinational corporation with a subsidiary in Spain and you are concerned about the purchasing power of the Euro and how it will influence your company and its operations in Spain.  To better understand the situation, you collect the following information:

 

1. Your expatriates in Spain tell you that the McDonalds Big Mac costs €2.55.  You know that the Big Mac costs US$2.85 in the US.  Given this information what is the exchange rate at which the Law of One Price holds between the US dollar and the Euro?  
2. The actual Euro/US dollar exchange rate is €0.95 = US$ 1.  Is the Euro over valued or undervalued as measured by purchasing power parity applied to the Big Mac?
3. The actual exchange rate is 1.0525USD = EUR 1 and the general level of inflation as measured by the consumer price index is expected to be 6 percent per year in Spain this year and 4 percent in the U.S.  If the rates of inflation in both of these countries continue at these levels for the next year, what would you expect the exchange rate to be in one year if relative purchasing power parity holds?
4. If the one year forward rate you are quoted is 0.935 € = US$ 1 and US one year interest rates are 5.75% per annum, what must the one year Spanish interest rates be if you assume covered interest rate parity holds?

Answer rating: 100% (QA)

The Law of One Price states that the same good should have the same price in different countries once the price is converted to a common currency usin... View the full answer