Question # 10:
If the interest rate in the United Kingdom is 8% the interest rate in the US is 10%, the spot exchange rate is $1.75/£ and interest rate parity holds, what must the one-year forward exchange rate?
Question # 11
Suppose all of the conditions in question 10 hold except that the forward rate of exchange is also $1.75/£. How could an investor take advantage of this situation?
The relationship between forward rate and spot rate can be notated in the following equation:
f 1+IR1 m
- = ( --------- )
Also can be written the following way:
f / s = [(1+IR1)/(1+IR2)]^m
Where f = Forward exchange rate
s = Spot exchange rate
IR1 = US's interest rate (10%)
IR2 = UK's ...
There are two problems here regarding exchange rate between US and UK.