Champagne PPP. Brazil recently experience a lot of currency fluctuation which is due in large part to the deteriorating economic conditions and the political upheaval brought about by a long running corruption scandal which culminated in the impeachment of President Dilma Rousseff. Given the recent economic and political instability it is important to gain a better understanding of the fundamental forces of exchange rate determination. In particular, you wonder whether the Brazilian real (BRL) is over- or undervalued by fundamental factors. You are a junior investment banker at a major Wall Street player specializing in Latin America just about to acquire your own portfolio of clients in late 2016. On a recent trip to pitch business to an important client in Sao Paolo, Brazil, you notice that a bottle of Veuve Cliquot champagne costs BRL 150 at a Sao Paolo airport gourmet store. When leaving the US, you had seen the same bottle for USD 45 at JF Kennedy Airport in New York, NY. An idea slowly takes shape how you could come up with an estimate of fundamental USD-BRL FX rates.

(1) If the current spot FX rate is BRL 3.5709/USD (December 01, 2016) what is the real exchange rate? Is the BRL overvalued or undervalued?

(2) Inflation is expected to run between 4.5% in Brazil (official target rate of the Central Bank for 2017) and 5% (OECD forecast for 2018). In the US, the OECD expects it to run at about 2.2% in the next year. What is a good estimate of the future BRL/USD spot rate?