Question

a)What is the expected relationship between the relative real interest rates of two countries and the exchange rate of their currencies?

b.   Assume that the level of capital flows between the U.S. and the country of Krendo is negligible (close

to zero) and will continue to be negligible. There is a substantial amount of trade between the U.S. and the country of Krendo and no capital flows. How will high inflation and high interest rates affect the value of the kren (Krendo’s currency)? Explain.

Answer 1

a) The expected relationship between the relative real interest rates of two countries and the exchange rate of their currencies is such that it eliminates arbitrage opportunities such as a risk-free gain from borrowing/lending and investing in the money market.

The following interest rate parity equation illustrates the relationship in mathematical form:-

(1+interet rate in A) = (Forward/Spot)*(1+Int rate in B)

This equation can be further approximated to:-

Int rate of A - Int rate of B = (Fwd-Spot)/Spot

If forward rate in this equation were not consistent with the corresponding interest rates there would be a clear arbitrage opportunity to earn a risk-free profit by directly converting the currency in the spot market then investing it and locking in the forward exchange rate. However, these actions would result in an increase in spot rate and a decrease in forward rate until equilibrium is achieved.

We can conclude that higher real interest rate of a country leads to a stronger home currency.

b) Since there is negligible capital flows between Krendo and US the high interest rates will not impact the exchange rates much (no capital flows) however, inflation will bear a direct impact on the trade, assuming that the trade is balanced between the 2 countries high inflation rate will cause the Kren to lose value against US.