# Determining and Forecasting the Exchange Rates.

Please see attachment.

1. Two countries, the United States and England, produce only one good, wheat. Suppose the price of wheat is $3.25 in the United States and is 1.35 pounds in England.

a. According to the law of one price, what should the $: Pound spot exchange rate be?

b. Suppose the price of wheat over the next year is expected to rise to $3.50 in the United States and 1.60 pounds in England. What should the one-year $: pound forward rate be?

c. If the U.S. government imposes a tariff of $0.50 per bushel on wheat imported from England, what is the maximum possible change in the spot exchange rate that could occur?

2. If expected inflation is 100% and the real required return is 5%, what will the nominal interest rate be according to the Fisher effect?

3. Suppose that in Japan the interest rate is 8% and inflation is expected to be 3%. Meanwhile, the expected inflation rate in France is 12%, and the English interest rate is 14%. To the nearest whole number, what is the best estimate of the one-year forward exchange premium (discount) at which the pound will be selling relative to the French Franc.

4. Suppose the spot rates for the Euro, pound sterling, and Swiss franc are $0.92, $1.13 and $0.38, respectively. The associated 90-day interest rates (annualized) are 8%, 16%, and 4%; the U.S. 90 day rate (annualized is 12%. What is the 90-day forward rate on an ACU (ACU1=E1+Pound 1+ SFr1) if interest parity holds?

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5. Assume the interest rate is 16% on pounds sterling and 7% on euros. At the same time, inflation is running at an annual rate of 3% in Germany and 9% in England.

a. If the Euro is selling at a one-year forward premium of 10% against the pound, is there an arbitrage opportunity? Explain

b. What is the real interest rate in Germany? In England?

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1. Two countries, the United States and England, produce only one good, wheat. Suppose the price of wheat is $3.25 in the United States and is 1.35 pounds in England.

a. According to the law of one price, what should the $: Pound spot exchange rate be?

The exchange rate should be such that the purchasing power parity is maintained. Thus,

$: Pound Spot Exchange rate should be

3.25/1.35=$2.4074/ pounds

b. Suppose the price of wheat over the next year is expected to rise to $3.50 in the United States and 1.60 pounds in England. What should the one-year $: pound forward rate be?

The forward rate should be such that the purchasing power parity is maintained.

Thus $: pound forward rate should be

3.50/1.60=$2.1875/ pound

c. If the U.S. government imposes a tariff of $0.50 per bushel on wheat imported from England, what is the maximum possible change in the spot exchange rate that could occur?

If the US Government imposes a tariff of $0.50 per bushel on wheat, the effective price of wheat in US would become $3.75.

Thus ...

#### Solution Summary

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