Following information is available.

1) Using the Relative Purchasing Power Parity, forecast the future spot rate one year from now.

2) Using the International Fisher Effect, forecast the future spot rate one year from now.

Solutions

Expert Solution

The future spot rate one year from now as per Purchasing power partity

The formula for computing the forward rate using the inflation rates in domestic and foreign countries is as follows:

F = S(1+iD)/(1+iF)

Where F= Forward Rate of Foreign Currency and

S= Spot Rate

iD = Domestic Inflation Rate and

iF= Inflation Rate in foreign country

Thus PPP theory states that the exchange rate between two countries reflects the relative purchasing power of the two countries i.e. the price at which a basket of goods can be bought in the two countries.

F = 1.14*(1+0.02)/(1+0.05)

F = USD 1.1074/ EURO

International Fisher Effect (IFE):

According to this theory, ‘nominal risk-free interest rates contain a real rate of return and anticipated inflation’. This means if investors of all countries require the same real return, interest rate differentials between countries may be the result of differential in expected inflation.

F = S (1+rD)/(1+rF)

where

S = Spot rate

rD = domestic rate if interest

rF = foreign rate of interest

F = 1.14*(1+0.04)/(1+0.06)

F = USD 1.1185/ EURO

1. F = USD 1.1074/ EURO

2. F = USD 1.1185/ EURO

Junaid answered 1 year ago

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