Question

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.

Answer 1

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

Spot 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%