Question

Assume that annual interest rates in the U.S. are 4.5 percent, while interest rates in U.K.

     are 3.2 percent.

1. According to IRP (using the exact formula), what should the forward rate premium or discount of the BP (British Pound) be?

2. If the BP’s spot rate is $1.3067, what should the one-year forward rate of the British pound be? (3 points)

Answer 1

As per IRP, the Real Interest rate across globe should be same, if any country is offering a larger rate, then that country's currency will depreciate and the net effect will get nullified. So an investor who plans to invest in the country with high interest rate will not earn higher profit as when he will try to convert the currency, he will incur loss as the currency has depreciated.

a) Here UK is offering lower interest rate, so if someone plans to borrow from UK and invest in US, then US currency will depreciate at the end of year or you may say that British pound will appreciate.

Forward Rate Premium/Discount = {(1 + Interest rate Foreign) / (1 + Interest Rate Domestic)} - 1

Foreign Interest Rate = US interest rate as we are thinking base currency to be GBP

Domestic Interest rate = UK interest rate as we are planning to borrow from here and invest in foreign with higher interest.

= {(1 + 4.5%) / (1 + 3.2%)} - 1

= 1.25%

So the Forward Premium of British Pound should be 1.25%

b) If Spot rate is $1.3067/GBP, then as it will trade at premium so,

= 1.3067 + 1.25% of 1.3067

= 1.3230

So British pound will appreciate. Earlier by 1 BP you were getting Dollar 1.3067 and now you will get more dollars, that is $1.3230