1.Long-Run Exchange Rate Risk

Assume you have undertaken a 3-year investment abroad with expected cash flows denominated in your chosen currency. At the current spot rate those cash flows are expected to provide a positive net present value (NPV) in US dollar terms. Based on relative purchasing power parity you are asked to estimate future spot rates over the next three years based on comparative inflation data.[1] With that data complete the table below.

S₀ = Current Spot Rate in European Terms (Foreign currency per US dollar) = $.9086

h_US=Annual Inflation Rate in the United States = .0225

h_FC =Annual Foreign Country Inflation Rate = .0198

Using the data above and textbook equation (18.3) E(S_t) = S₀ [1 + (h_FC - h_US)]^t and assuming the estimated inflation rate in Year 1 also holds for Years 2 and 3, please respond to the following:

a)Based on relative purchasing power parity, estimate S_1.

b)Based on relative purchasing power parity, estimate S_2.

c)Based on relative purchasing power parity, estimate S_3.

d)Based on relative purchasing power parity, has the foreign currency appreciated or depreciated against the US dollar?Explain.

e)Based on relative purchasing power parity, has the NPV of the investment project increased or decreased in US dollar terms? Explain.