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    Solve: Interest Rate Parity and Purchasing Power Parity

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    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?

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    Solution Preview

    1.
    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.

    $2.19

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