Assume that inflation in the U.S. is expected to be 9%, while inflation in Australia is expected to be 5% 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

Purchasing power parity suggests that the currency with higher inflation (USD) will depreciate relative to the currency with lower inflation (AUD). Since the AUD is expected to appreciate, the put option (which profits from a decline in AUD) is not a favorable investment.

Assume That Inflation in the U