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Risk ManagementRisk managementPurchasing Power ParitySection B
This question is part of a case study — click to read the full scenario(Case 26)

Section B - Case 3: GlobalLogix

Scenario: GlobalLogix is a cross-border logistics firm based in the Eurozone (€). The company expects to receive $2,000,000 from a US client in 3 months' time.
Current spot rate ($/€): 1.1500 - 1.1550
3-month forward rate ($/€): 1.1600 - 1.1660
Eurozone interest rates: Borrow 2.0% per year, Deposit 1.0% per year.
US interest rates: Borrow 4.0% per year, Deposit 3.0% per year.

If GlobalLogix uses a forward contract to hedge this receipt, how many Euros (€) will they receive in 3 months?

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ACCA · Question 29 · Risk Management

Section B - Case 3: GlobalLogix

Scenario: GlobalLogix is a cross-border logistics firm based in the Eurozone (€). The company expects to receive $2,000,000 from a US client in 3 months' time.
Current spot rate ($/€): 1.1500 - 1.1550
3-month forward rate ($/€): 1.1600 - 1.1660
Eurozone interest rates: Borrow 2.0% per year, Deposit 1.0% per year.
US interest rates: Borrow 4.0% per year, Deposit 3.0% per year.

Assume the annual inflation rate is expected to be 3.0% in the US and 1.5% in the Eurozone. Using Purchasing Power Parity (PPP), forecast the expected spot rate ($/€) in exactly one year's time. Use the spot rate of 1.1550 as your base.
(Provide your answer to four decimal places, e.g., 1.1234).

How to approach this question

Use the PPP formula: S1 = S0 * [(1 + hc) / (1 + bc)]. Here, the quote is $/€, so $ is the variable currency (numerator) and € is the base currency (denominator).

Full Answer

Purchasing Power Parity (PPP) predicts future spot rates based on inflation differentials. Formula: $S_1 = S_0 \times \frac{1 + h_c}{1 + b_c}$ Where $S_0$ is the current spot rate, $h_c$ is inflation in the country of the variable currency ($), and $b_c$ is inflation in the country of the base currency (€). $S_0 = 1.1550$ $h_c (US) = 0.03$ $b_c (Eurozone) = 0.015$ $S_1 = 1.1550 \times \frac{1.03}{1.015}$ $S_1 = 1.1550 \times 1.014778$ $S_1 = 1.172069$ Rounded to four decimal places: 1.1721.

Common mistakes

Putting the Eurozone inflation in the numerator and US inflation in the denominator.
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