Question

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As a part of your analysis of your foreign currency exposure, each group of students is...

As a part of your analysis of your foreign currency exposure, each group of students is asked to: 1. Determine and provide details of the forward rate of the currency that you are trading in. With reference to the current interest rates, determine if interest rate parity exists between your home territory and your country of trade. 2. Based your assumptions indicate the expected future trend of the exchange rate between your home territory and your country of trade.

Expert Solution

(1) The currency that I have traded in is British Pound (£).

Determination of Forward Exchange Rate of Currency :

In order to start with we should know the Exchange rate of the currency. Exchange Rate of US $ and Bristish £ on 1 April 2020 was $1.2379 per £ which is the Spot Exchange Rate. Interest Rate in US is 3.5% and that in UK is 3%.

Formula to Calculate Forward Exchange rate is

Here, F = Forward Exchange Rate , S = Spot Exchange Rate, Id = Domestic Interest Rate, If = Foreign Interest Rate & n = Time period in number

F = 1.2379* (1+ 3.5%/ 1+ 3%)^{1}

F = 1.2379* (103.5/103)

Forward Exchange Rate = $1.2439 per £ .

Interest Rate Parity is the relationship between Interest rate of two different currencies and the spot and forward exchange rates of those currencies.

Here we need to calculate the ratio of Forward to Spot exchange rate and match it with the rate of return of both the currencies:

Lets assume that the Actual Forward Exchange Rate is $1.3933

Ratio of Forward to Spot Exchange rate : 1.3933/1.2379 = 1.1255

Rate of Return : (1+ 3.5%/ 1+ 3%)^{1} = 1.004

As the Ratio of forward to spot exchange rate & rate of return are not equal, So Interest Rate Parity doesn't exists.

(2) As we know that the Forward Exchange rate is highly dependent on changes in the interest rates and inflation in home and foreign countries. So if the interest rate in home country increases as compared to the foreign country then the forward exchange rate will be higher. However if the opposite happens then the forward exchange rate will be lower. Also inflation effects the exchange rate of the country as high Inflation in home country can lead to decrease in the value of home currency and increase in value of foreign currency.

For Example : If earlier 1 US$ is equal to 0.80 British £ and due to some situations inflation increases in United States which makes everything costly and due to this the value of US$ decreases and now 1 US$ is equal to 0.71 £ , in this situation value of British Pound has appreciated in value. Finally this will impact the forward exchange rate also.

jeff jeffy answered 2 years ago

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