Question

Suppose that the one-year interest rate is 10 percent in the United Kingdom. The expected annual rate of inflation for the coming year is 4 percent for the United Kingdom and 7 percent for Switzerland. The current spot exchange rate is £:SFr = 3.75. Using the precise form of the international parity relations, compute the one-year interest rate in Switzerland, the expected Swiss franc to pound exchange rate in one year, and the one-year forward exchange rate.

Answer 1

1)

As per international fisher effect, the real rate of interest between two countries always remain equal. And the difference in nominal interest rates between two countries always occurs due to difference in Inflation rates of that two countries.

It means    Real rate of UK = Real rate of Switzerland

So,            [(1.10)/(1.04)] - 1 = [ (1+ I)/1.07] -1

   0.05769 = [ (1+ I)/1.07] -1                                                 

                        1.05769*1.07 = 1 + I

                                            I = 13.17 %

So, One year interest rate in Switzerland = 13.71%

2)

Exchange rate = 3.75SFr/ £

As per interest rate parity model

One year forward exchange rate = Spot price * (1+0.1317)/(1+0.10)

One year forward exchange rate = 3.75 * 1.028818

One year forward exchange rate = 3.858 or 3.86 (Approximately)

So, One year forward exchange rate = 3.86 SFr / £

This is also the expected Swiss franc to pound exchange rate in one year. (i.e. 3.86 SFr / £ )