Question

Suppose that U.S. inflation is 3%; inflation in British pounds is 6% and the spot exchange rate is £1 = $2.

What is your estimate of the exchange rate expected to prevail in 3 years?

Answer 1

F / S = (1 + Inflation Rate in Home Country)^No of Years / (1 + Inflation Rate in Foreign Country)^No of Years
Where,
Home Country = U.S.A
Foreign Country = U.K.
F = Forward Rate
S = Spot Rate = (£1 = $2)
Inflation Rate in Home Country = 3% = 0.03
Inflation Rate in Foreign Country = 6% = 0.06
No of Years = 3
Therefore,
F / S = (1 + Inflation Rate in Home Country)^No of Years / (1 + Inflation Rate in Foreign Country)^No of Years
F / $2 = (1+0.03)³ / (1+0.06)³
F = (1.092727 / 1.191016) * $2
F = 1.83
So, Exchange Rate in 3 Years will be £1 = $1.83