MC Question 22
ZPS Co, whose home currency is the dollar, took out a fixed-interest peso bank loan several years ago when peso interest rates were relatively cheap compared to dollar interest rates. ZPS Co does not have any income in pesos. Economic difficulties have now increased peso interest rates while dollar interest rates have remained relatively stable.
ZPS Co must pay interest on the dates set by the bank. A payment of 5,000,000 pesos is due in six months’ time. The following information is available:
| Spot rate | 12·500–12·582 pesos per $ |
| Six-month forward rate | 12·805–12·889 pesos per $ |
| Borrow | Deposit | |
|---|---|---|
| Peso interest rates | 10·0% per year | 7·5% per year |
| Dollar interest rates | 4·5% per year | 3·5% per year |
Which of the following statements relate to purchasing power parity theory?
(1) The theory holds in the long term rather than the short term
(2) The exchange rate reflects the different cost of living in two countries
(3) The forward rate can be found by multiplying the spot rate by the ratio of the interest rates of the two countries
A. 1, 2 and 3
B. 1 and 2 only
C. 1 and 3 only
D. 2 only