Question

Two countries, Great Britain and the United States, produce just one good: beef. Suppose that the price of beef in the United States is $2.80 per pound, and in Britain it is £3.70 per pound.

(a) According to purchasing power parity (PPP) theory, what should the $/£ spot exchange rate be?

The Purchasing power parity is an exchange rate that compare different countries’ currencies through the prices of identical products or services. The prices vary due to transportation costs, taxes, and tariffs.

Formula:         E_$/£ = P_$ / P_£

The P_$ is the U.S. dollar price of beef and P_£ is the price of the same product in Britain pound.

                        0.757 = $2.80 / £ 3.70

According to PPP theory, the exchange rate should be: 0.757

£1 = $ 0.76 or $1 = £1.32

(b) Suppose the price of beef is expected to rise to $3.10 in the United States and to £4.65 in Britain. What should be the 1-year forward $/£ exchange rate?

Formula:         E$/£ = P$ / P£

                        0.67 = $3.10 / £ 4.65

According to PPP, the one year forward exchange rate should be: 0.67

£_{1 =} $ 0.67 or $_{1 =} £1.50

(c) Given your answers to parts (a) and (b), and given that the current interest rate in the United States is 10%, what would you expect the current interest rate to be in Britain?

The British interest rate is expected to be 23.49%

Formula:         (S₁ – S₂) S₂ x 100 = i_£ - i_$

Where S₁ is the initial spot exchange rate (a) and S₂ the final spot exchange rate after rise of prices (b), and i represents the nominal interest rates for Britain and the United States

            (0.757 – 0.667) / 0.667 x 100 = i£ - 10

                                                13.49 = i£ - 10

                                               23.49% = i£

The interest rate in the United States is 10% and in Britain it is 23.49%, we would expect the value of the pound to depreciate by 13.49% against the U.S. dollar.

QUESTION:

given the data above regarding the price of beef, if you are the CFO for a major restaurant chain where would you recommend purchasing beef in the US or Britain for 2019 (assuming that there is no impact from tariffs, transportation and the quality of the product is the same in both countries)? Why?

Answer 1

Ans. I'll prefer purchasing beef from Britain for 2019 because it have been clearly mentioned and is very clear that British pound is weaker against the dollar and in part c also we see that it would depreciate further in the future. Hence , we conclude that beef would be cheaper in Britain as compared to US , hence we would prefer Britain

Best of Luck !! !!