Assume that the U.S. one-year interest rate is 3 percent and the one-year interest rate on Australian dollars is 6 percent. The U.S. expected annual inflation is 5 percent, while the Australian inflation is expected to be 7 percent. You have $100,000 to invest for one year and you believe that PPP holds. The spot exchange rate of an Australian dollar is $0.689. What will be the yield on your investment if you invest in the Australian market?

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Quizplus · Accepted Answer

According to the PPP theory, the exchange rate of two currencies should adjust to reflect the difference in inflation rates between the two countries, which means that the Australian dollar should depreciate by 2 percent (7%-5%) to keep the purchasing power parity. Therefore, the expected exchange rate in one year will be $0.689 x (1-2%) = $0.67522.
Now, to calculate the yield on our investment in the Australian market, we need to convert our $100,000 into Australian dollars, which is $100,000 / $0.689 = AUD 145,236.79. 
After one year, the investment will yield AUD 145,236.79 x 1.06 = AUD 154,082.45. 
Converting this amount back to U.S. dollars using the new exchange rate of $0.67522, we get $104,020.32. 
Therefore, the yield on our investment will be (104,020.32-100,000) / 100,000 x 100% = 4 percent, which is equivalent to the difference between the Australian interest rate and the U.S. interest rate adjusted for the expected depreciation of the Australian dollar.

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