In this question you are to assume that both purchasing power parity and interest rate
parity hold. I am going to give you information on current and future expected price
levels (as measured by the price of a Starbuck’s venti latte) for the United States and
Switzerland. I will also tell you what the current one-year interest rate is in the U.S.
You are to figure out what the current interest rate must be in Switzerland.
United States Switzerland
Current price of a
Starbuck’s venti latte $4.85 SF5.35
Price of latte expected
one year from now $5.10 SF5.45
One-year interest rate 6% ?
Using both purchasing power parity and interest rate parity, what must the one-year
interest rate be in Switzerland? Show work.
The interset parity is the condition where an exchange rate between the two currencies will change according to the interest rate differential in those two countries.
Similarly, the purchasing power parity condition confirms that the price of goods will be equal adjusted to the exchange rate in both countries.
We have been given prices of coffee in the US and Switzerland for the year t and t+1.
We can calculate the spot rate and 1-yer forward rate
5.35 / 4.85 = 1.1031
1 Swiss Franc = 1.1031 US Dollar
1 year Forward Rate
5.45 / 5.10 = 1.0686
Interest Rate Parity Condition
Forward Rate / Spot Rate = (1+Interest Rate in Quote Currency) / (1+Interest Rate in Base Currency)
1.0686 / 1.1031 = (1+Interest Rate in Swiss Frank) / (1.06)
0.9688 * 1.06 = (1+Interest Rate in Swiss Frank)
(1.0269 - 1) * 100 = 2.69%
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