Question

The “Market” section of the Bloomberg website provides interest rate quotations for numerous currencies. Its address is www.bloomberg.com.

1- Go to the “Rates and Bonds” section and then click on each foreign country to review its future rate of return.

2- Determine the prevailing 1-year interest rate (YTD return) of the Australian dollar, the Japanese yen, and the British pound.

3- Assuming a 2 percent real rate of interest for savers in any country, determine the expected rate of inflation over the next year in each of these countries that is implied by the nominal interest rate (according to the Fisher effect).

What is the approximate expected percentage change in the value of each of these currencies against the dollar over the next year when applying PPP to the inflation level of each of these currencies versus the dollar?

Answer 1

Assuming inflation in US is approximately 1%.

As per Bloomberg website,

1. YTD return of Australian Dollars = 5.31%

If real rate of interest = 2%, then as per Fisher effect, expected inflation = 3.31%.

Therefore, percentage change in exchange rate is expected to be = 3.31 - 1 = 2.31%

Current exchange rate : 1 AUD = 0.76 USD

Thus, expected exchange rate = 0.76 (1 - 0.0231) = 0.742 USD

2. YTD return of Yen = 13.79%

If real rate of interest = 2%, then as per Fisher effect, expected inflation = 11.79%.

Therefore, percentage change in exchange rate is expected to be = 11.79 - 1 = 10.79%

Current exchange rate : 1 Yen = 0.0089 USD

Thus, expected exchange rate = 0.0089 (1 - 0.1079) = 0.0079 USD

3. YTD return of british pound = 3.57%

If real rate of interest = 2%, then as per Fisher effect, expected inflation = 1.57%.

Therefore, percentage change in exchange rate is expected to be = 1.57 - 1 = 0.57%

Current exchange rate : 1 British Pound = 1.28 USD

Thus, expected exchange rate = 1.28 (1 - 0.057) = 1.207 USD