To determine: The spot exchange rate one-year from at present.
Introduction:
Two parties enter into an agreement to buy one currency against selling another currency at a predetermined price on a spot date. Here, the exchange rate wherein the transaction is done is termed as Spot exchange rate.
Explanation of Solution
Given information:
SK Country’s interest rate on government securities with one-year maturity is 4% and expected inflation rate of this country is 2%. The U Country’s interest rate on government securities is 7% and expected inflation rate is 5%. The spot exchange rate for SK Country is $1 = W 1,200.
The formula to compute the spot exchange rate one-year from at present using International Fisher effect (IFE) is as follows:
Here,
S1 refers to the spot exchange rate at the beginning of the period,
S2 refers to the spot exchange rate at the end of the period,
i$ refers to the nominal interest rate of U Country,
i2 refers to the nominal interest rate of another Country.
Compute the spot exchange rate one-year from at present:
Note 1: As per the IFE, the exchange rate would change in an equal amount, but in an opposite direction towards the variance in nominal interest rates. Therefore, the nominal interest will be 3%
Note 2: The S1 is the spot exchange rate at the beginning of the period of U Country and S2 is the spot exchange rate at the end of the period of SK Country.
Hence, the spot exchange rate one-year from at present is W1,165.04.
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International Business: Competing in the Global Marketplace
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