Question

We have the following information. The spot rate in the s/euro is .7 $/euro. What will the expected spot rate be, if the interest rates in the s and the euro are .04 and .09 respectively? Show both dollar and euro terms. Explain the meaning of your results. Does the aforementioned relate to inflation differences between the two currencies? Please show step by step solutions and formulas .

Answer 1

Spot rate = 0.7 $/ Euro
Expected spot rate = Current Spot rate * (1 + Interest rate of Base currency(Euro))/(1+Interest rate of Variable currency(Dollar))  = 0.7 * ( 1+ 0.09)/(1+0.04) = 0.73365 ( in dollar terms)

Current Spot rate in Euro terms = 1/dollar spot rate = 1/0.7 = 1.42857
Expected spot rate = Current Spot rate * (1 + Interest rate of Base currency(Dollar))/(1+Interest rate of Variable currency(Euro))  = 1.42857 * ( 1+ 0.04)/(1+0.09) =1.3630 ( in euro terms)

Meaning of above result is that the spot rate or exchange rate of a country increases if its interest rate is lower than foreign country and vice versa.

According to monetary policy higher interest rate is used in countries with higher inflation to reduce inflation by restricting money supply to the financial system, banks and others. So inflation has similar effect as interest rate.

Best of Luck. God Bless