Purchase Solution

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?

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.

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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 ( ...

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