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Expected exchange rate using interest rate parity

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Consider the following financial data:

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?

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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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