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Question about International Fisher Effect (IFE)

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24. Beth Miller does not believe that the international Fisher effect (IFE) holds. Current one-
year interest rates in Europe are 5 percent, while one-year interest rates in the U.S. are
3 percent. Beth converts $100,000 to euros and invests them in Germany. One year
later, she converts the euros back to dollars. The current spot rate of the euro is $1.10.

a. According to the IFE, what should the spot rate of the euro in one year be?

b. If the spot rate of the euro in one year is $1.00, what is Beth's percentage return from her
strategy?

c. If the spot rate of the euro in one year is $1.08, what is Beth's percentage return from her
strategy?

d. What must the spot rate of the euro be in one year for Beth's strategy to be successful?

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Solution Preview

a. According to the IFE, what should the spot rate of the euro in one year be?

If the IFE holds, the euro should depreciate by 1.90 percent in one year. This translates to a spot rate of $1.10 × (1 – 1.90%) = $1.079.

b. If the spot rate of the euro in one year is $1.00, what is Beth’s ...

Solution Summary

This posting provides a detailed solution to the given problem based on the International Fisher Effect.

$2.19
Similar Posting

Multiple choice questions in International Finance: Parity conditions

1) If the forward rate was expected to be an unbiased estimate of the future spot rate, and interest rate parity holds, then:

a) covered interest arbitrage is feasible.
b) the international Fisher effect (IFE) is supported.
c) the international Fisher effect (IFE) is refuted.
d) the average absolute error from forecasting would equal zero

2) According to the international Fisher effect, if U.S. investors expect a 5% rate of domestic inflation over one year, and a 2% rate of inflation in European countries that use the euro, and require a 3% real return on investments over one year, the nominal interest rate on one-year U.S. Treasury securities would be:

a) 2%.
b) 3%.
c) -2%.
d) 5%.
e) 8%.

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