Assume that inflation in the United States is expected to be 9 percent, while inflation in Australia is expected to be 5 percent over the next year. Today you receive an offer to purchase a one-year put option for $.03 per unit on Australian dollars at a strike price of $0.72. Today the Australian dollar is quoted at $0.70. You believe that purchasing power parity holds. You should accept the offer.

Question

Quizplus · Accepted Answer

According to the purchasing power parity (PPP) theory, the exchange rate should adjust to offset the inflation differential between two countries. With the U.S. expecting higher inflation (9%) than Australia (5%), the Australian dollar should appreciate relative to the U.S. dollar. Therefore, a put option (the right to sell Australian dollars at a fixed rate) would likely not be profitable if the Australian dollar is expected to strengthen, making the offer less attractive.

Assume That Inflation in the United States Is Expected to Be