Question

Suppose the current exchange rate is DM 1.4/$. Estimate the DM/$ exchange rate four years from now assuming that in the U.S. (Germany) are 6%. (4%) p.a. inflation rates stay constant each year How reliable is your estimate. Explain carefully? What does it mean to say that a currency is fully convertible?

Answer 1

Assuming that Germany is the domestic country and US is the foreign country we shall proceed as given below:

Current Exchange Rate = S = 1.4 DM / $

German Interest Rate = rd = 4 % and US Interest Rate = rf = 6%

Therefore, by covered interest parity relation, exchange rate after four years would be F4 = [(1+rd) / (1+rf)]^(4) x S

F4 = [1.04 / 1.06]^(4) x 1.4 = 1.297 DM / $

Although both covered interest parity and uncovered interest parity are reasonably accurate, they are only at best an estimate of the expected spot exchange rate of the future. This is because both relations are derived to function in an ideal world without speculator created discrepancies and were meant to function as at best estimate providers. They would be absolutely accurate only when forward rates predicted by them and the actual spot exchange rates of the future converge with each other which again is a highly idealistic scenario.

Full currency convertibility means that the currency under consideration can be converted into any other currency without any restrictions on the rate of conversion, amount to be converted, the frequency of conversion or time of conversion. It basically implies a currency free of regulatory capital controls, thereby being subject to only the forces of supply-demand and can be safely expected to be always at its fair value.