Step-by-step solution using Purchasing Power Parity (PPP):

PPP states that exchange rates adjust to reflect inflation differentials between countries. The country with higher inflation should see its currency depreciate.

The PPP formula is: $S_{new} = S_{old} \times \frac{(1 + \text{Inflation}_{quote})}{(1 + \text{Inflation}_{base})}$

Where:

• $S_{old}$ = Current spot rate = $1.1300 per EUR
• Quote currency = USD (inflation = 2.0%)
• Base currency = EUR (inflation = 5.0%)

Exact calculation: $S_{new} = 1.1300 \times \frac{1.02}{1.05} = 1.1300 \times 0.9714 = 1.0977$

Using the linear approximation (which is the standard approach in FRM materials): $S_{new} = S_{old} \times (1 + \text{Inflation}_{quote} - \text{Inflation}_{base})$ $S_{new} = 1.1300 \times (1 + 0.02 - 0.05) = 1.1300 \times 0.97 = 1.0961$

New EUR USD rate ≈ $1.0961

The answer is (a) $1.0961. Economic intuition: the Eurozone has higher inflation (5%) than the US (2%), so the EUR should depreciate against the USD (fewer dollars needed to buy one euro), which is exactly what the result shows.