Session 5 and 6- Small Cases
International Parity Condition
1. After the graduation, you expect to become a foreign exchange dealer. Your curiosity about the
behaviour of foreign exchange markets encourages you to conduct research on purchasing power
parity theory. Your research outcomes in relation to gold and foreign exchange market are as
follows:
Country
Price of Gold Oz as at 1st October 2016
Forecasted price-level changes in the six-month
period started at 1st October 2016
Spot exchange rate as at 1st October 2016
Spot exchange rate as at 31st March 2017
AUD
AUD1,715.52
1.23%
China
CNY8,768.19
2.80%
CNY5.2278/AUD
CNY5.3215/AUD
Required:
a. Given prices of gold and the absolute purchasing power parity theory (APPP), estimate the spot
exchange rates in terms of CNY for AUD as at 1st October 2016.
Spot exchange rate= 8,768.19𝐴𝑈𝐷 / 1,715.52𝐶𝑁𝑌 = 𝐶𝑁𝑌 5.1111/𝐴𝑈𝐷
b. Does the AUD undervalue or overvalue against CNY? (Use your answer for (a) above and the
exchange rate given as at 1st October 2016). What is the percentage change of overvaluation or
undervaluation?
AUD has overvalued by 2.28%, [(5.2278−5.1111) / 5.1111 ], against CNY
c. How can you explain the possible impact of the current overvaluation or undervaluation of AUD
on the future value of AUD in CNY?
Since AUD has overvalued, it should depreciate in the immediate future to correct the
market anomaly on overvaluation.
d. If relative purchasing power parity theory holds during that period, what would be the spot
exchange rate as at 31stMarch 2017 in terms of CNY to AUD? (Use given actual spot rates as at 1st
October 2016 and the annual inflation rates.)
5.2278 × (1.028 / 1.0123) = 𝐶𝑁𝑌5.3089 / 𝐴𝑈𝐷
e. During the 6-month period, did the AUD appreciate or depreciate in real terms against the CNY? If
so, what is the percentage change in value?
AUD has appreciated in terms of real value by 0.23%, against CNY
f. Explain how the purchasing power parity theory can be used for making business finance
decisions.
PPP can be used for pricing of import and export product, estimating expected FX rate, to
identify the market opportunities.