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    Expected exchange rate using interest rate parity

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    Consider the following financial data:

    UK DM
    Inflation (expected annual) 10% 4%
    1 Year Interest Rate 12% ??
    Spot Exchange Rate (DM/pound) 3

    Assuming the international parity conditions hold perfectly, what is the expected exchange rate in one year?

    © BrainMass Inc. brainmass.com March 4, 2021, 5:37 pm ad1c9bdddf
    https://brainmass.com/business/international-finance/expected-exchange-rate-using-interest-rate-parity-3111

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    (1+ r £ ) / (1+ r DM ) = (1+ i UK ) / (1+ i GER )

    or (1+0.12) / (1+ r DM ) =(1+0.10) / (1+0.04)

    or 1.12 / (1+ r DM ) = 1.0576

    or (1+ r DM ) = 1.12/ 1.0576 =1.0589

    0r r DM = 1.0589-1= 0.0589 or 5.89%

    As an approximation difference in inflation rate= difference in interest rates

    difference in inflation rate = 10%-4%=6%
    Therefore difference in interest rate will be 6 %. The country having higher inflation will have a higher interest rate ( ...

    Solution Summary

    The solution calculates the expected exchange rate using interest rate parity conditions. The interest rates are determined using inflation rates and then the expected exchange rate is calculated.

    $2.49

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