Chapter 10, Problem 1CTD

Summary Introduction

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:

$\frac{{\text{S}}_1-{\text{S}}_2}{{\text{S}}_2}\times 100={\text{i}}_{\$}-{\text{i}}_2$

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% $\left(7\%-4\%\right)$ relative to the SK Country’s currency.

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.

$\begin{array}{c}\frac{{\text{S}}_1-{\text{S}}_2}{{\text{S}}_2}\times 100={\text{i}}_{\$}-{\text{i}}_{\text{W}}\\ \frac{\text{1,200}-{\text{S}}_2}{{\text{S}}_2}\times 100=\frac{7}{100}-\frac{4}{100}\\ \frac{\text{1,200}}{{\text{S}}_2}-\text{1}=0.07-0.04\\ \frac{\text{1,200}}{{\text{S}}_2}=0.03+1\\ \frac{\text{1,200}}{{\text{S}}_2}=\text{1}\text{.03}\\ \frac{1,200}{1.03}={\text{S}}_2\\ \text{1,1}65.04={\text{S}}_2\end{array}$

Hence, the spot exchange rate one-year from at present is W1,165.04.