How PPP is a way of defining the equilibrium exchange rate.

(a) Explain how PPP is a way of defining the
equilibrium exchange rate. [5 marks]

(b) Assess how you would construct an arbitrage portfolio for
Miss Catalea. You must support your answer with appropriate
calculations. [10 marks]

(c) Regress the rate of exchange rate changes on the inflation rate
differential to estimate the intercept and the slope coefficient.
Provide interpretation of the regression results. [10 marks]

(d) Based on your knowledge of the efficient market approach
and hedging evaluate the statement that “changes in exchange
rates affect the settlement of contracts, cash flows and the firm
valuation.” And advice Miss Catalea about the possible
implications for FEMKX.

Sample Solution

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