Question

From the news, you identified a trend that Mexican nominal interest rates have been substantially higher than U.S. nominal interest rates in recent years.

1. According to Fisher Effect, what do you expect inflation gap between two country’s inflation rate?

2. What does this imply about the future changes to Mexican peso vs. USD exchange rate and why? (explain with parities you have learned)

3. Assume three months later, the annual interest rate is 10% in Mexico and 1.5% in the US, the spot rate is $0.05 per peso and the one year forward rate is $0.048 per peso. Is interest rate parity holds? If not, can your company take advantage of this arbitrage opportunity? How much is your profit if you have $1million?

4. Since Mexican nominal interest rate is often substantially higher than U.S. interest rate. What is the future spot rate of peso vs. USD when you use peso/USD forward rate to forecast future spot rate? Based on which parity do you make your predication here?

5. What would you expect the gap of interest rate differentials affects the degree of expect changes on peso vs. USD exchange rate?

6. What other forecast methods you can use to forecast peso exchange rate in the future? Please explain each forecast method’s advantages and disadvantages respectively.

Answer 1

1) The Fisher Effect is an economic theory created by economist Irving Fisher that describes the relationship between inflation and both real and nominal interest rates. The Fisher Effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate. Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the same rate as inflation.

In the given question  Mexican nominal interest rates have been substantially higher than U.S. nominal interest rates therefore the gap in the inflation is the difference in the nominal rates of both countries.

2)Since the nominal rate of interest is more at mexico and less in US the USD will gain the value compared to Mexico and if the interest rate parity holds good then the difference in forward rate will be equal to the difference in the Spot exchange rate

3) find attachment