PPP and Cash Flows. Boston Co. will receive 1 million euros in one year from sel

Question

PPP and Cash Flows. Boston Co. will receive 1 million euros in one year from selling exports. It did not hedge this future transaction. Boston believes that the future value of the euro will be determined by purchasing power parity (PPP). It expects that inflation in countries using the euro will be 12% next year, while inflation in the U.S. will be 7% next year. Today the spot rate of the euro is $1.46, and the one-year forward rate is $1.50.

Estimate the amount of U.S. dollars that Boston will receive in one year when converting its euro receivables into U.S. dollars.

      4 Marks

Explanation / Answer

ACCORDING TO PPP THEORY

EXPECTED EURO RATE AFTER A YEAR = SPOT RATE*(1+US RATE)/(1+ EURO RATE)

EXPECTED EURO RATE AFTER A YEAR = $1.46*(1+0.07)/1.012) = $1.3948

EXPECTED AMOUNT OF DOLLAR RECEIVABLE AFTER A YEAR = 1 MILLION X $1.3948

EXPECTED AMOUNT OF DOLLAR RECEIVABLE AFTER A YEAR = $1394800 ANSWER

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