Question

If the spot rate for Swiss Francs versus US Dollars is one SF equals 1.1 US $, and the annual interest rate on fixed rate one-year deposits of SF is 0.5% and for US$ is 2%, what is the nine-month forward rate for one dollar in terms of SF? Assuming the same interest rates, what is the 18-month forward rate for one SF in US$? Is this an indirect or direct rate? If the forward rate is an accurate predictor of exchange rates, in this case will the SF get stronger or weaker against the US dollar? What does this indicate about the market’s inflation expectations in Switzerland compared to the US?

Answer 1

Spot Rate:1SF=1.1USD

Interest rate in SF =0.5%=0.005

Nine months interest =0.005*(9/12)=0.00375

Future Value of 1 SF after nine months=1*(1+0.00375)=1.00375 SF

Interest rate in USD =2%=0.02

Nine months interest =0.02*(9/12)=0.015

Future Value of 1.1 USD after nine months=1.1*(1+0.015)=1.1165 USD

Nine month forward rate : 1.1165 USD=1.00375SF

Forward Rate for One Dollar (1 USD)=(1.00375/1.1165) SF=0.8990 SF

This is INDIRECT Rate of SF in USA. In Indirect rate , the home currency is fixed (in this case 1 USD) and the foreign currency is expressed in terms of fixed home currency.

18 month Forward Rate:

18 month interest in SF=0.005*(18/12)=0.0075

18 month interest in USD =0.02*(18/12)=0.03

Future Value of 1 SF at end of 18 months =1*(1+0.0075)=1.0075 SF

Future Value of 1.1 USD at end of 18 months =1.1*(1+0.03)=1.133 USD

18 month forward rate : 1.0075SF=1.133USD

Forward Rate of 1 SF =(1.133/1.0075)USD=1.1246 USD

In this case , the foreign currency (SF ) is fixed (1 SF) and the exchange rate is expressed in terms of home currency . Hence, it is direct rate of SF in USA

In this case SF gets stronger because more USD is available for 1 SF

Inflation in USA will be higher because the interest rate is an indicator of inflation.Inflation in Switzerland will be lower than in USA