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International Financial Management

Integrating IRP and IFE. Assume the following information is available for the U.S. and Europe:

U.S. Europe

Nominal interest rate 4% 6%

Expected inflation 2% 5%

Spot rate - $1.13

One-year forward rate - $1.10

a. Does IRP hold?

b. According to PPP, what is the expected spot rate of the euro in one year?

c. According to the IFE, what is the expected spot rate of the euro in one year?

d. Reconcile your answers to parts (a). and (c).

Solution Preview

Please see the attached file for the detailed solution.

a. Does IRP hold?

rd=4%

rf=6%

e0=$1.13

F1=$1.10

According to IRP F1 = (1+rd)/(1+rf)*e0

So we have F1=(1+4%)/(1+6%)*1.13=1.1087

As the calculated forward rate is slightly higher than the market forward rate, IRP does not ...

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