Imagine the exchange rate between the British pound (£) and the U.S. dollar ($) is fixed at $1.40/£ and capital flows freely between Great Britain and the U.S. Explain what the price of shares of stock in XYZ Inc. would be selling for in London if they are $80 per share in the U.S. and why.
What will be an ideal response?
Each share would sell for 57.14£s in Great Britain. We can get to this answer using the concepts of purchasing power parity and arbitrage. If the price were higher, say 60£s, investors would purchase the shares in the U.S. for $80.00, which would only require 57.14 £ s, sell the shares in London for 60 £s and make a profit of 2.86 £s or $4.00 per share, (this analysis ignores commissions). When capital flows freely between countries, the process of arbitrage will result in the prices of goods equalizing across markets (ignoring transactions costs).
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