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Solve: Interest Rate Parity and Purchasing Power Parity

Please answer the following two problems:

1: Interest Rate Parity
The current 90-day interest rate in the United States is 1 percent. The current 90-day interest rate in France is 2
percent. The current spot rate for the French franc (FF) is $0.18679/FF. If the interest rate parity (IRP) holds between the United States and France, what is the expected 90-day forward rate?

2: Purchasing Power Parity
The economists at DRI, Inc. have recently forecasted a U.S. inflation rate of 3 percent over the coming year. In their world economic outlook report, they have forecasted an inflation rate of 6 percent in Italy over the coming year. The current spot rate of exchange for the Italian lira is $0.0006323. If purchasing power parity (PPP) holds, what would your forecast be for the dollar value of the lira in one year?

Solution Preview

USD/FF spot is $0.18679 / FF.

90 day interest rate on $ is 1%.
90 day interest rate on FF is 2%.

According to the interest rate parity condition:
Forward/Spot = (1+ USD interest rate) / (1+ FF interest ...

Solution Summary

This solution is comprised of a step by step response based on interest rate parity (IRP) and purchasing power parity (PPP). The value for the expected 90-day forward rate is calculated and the forecasted dollar value of the lira in one year is computed.