Question

Suppose the U.S.-Indian rupee exchange rate is 0.01 $ / rupee. Suppose interest rates in India are 15% and 5% in the United States. Based on the interest rates, the rupee is expected to (appreciate or depreciate) by ___________%

What should the forward rate for the $ / rupee rate be? __________

Answer 1

Solution:

Using the interest rate parity, we can find the following:

Expected exchange rate = exchange rate*(1 + foreign interest rate - home interest rate)

So, we get expected exchange rate = 0.01*(1 + 0.05 - 0.15) = 0.009$/Re

Notice that expected exchange rate is 0.011$/Re, meaning it is expected that one Re could purchase dollar worth $0.009, rather than $0.010, which is less now. In other words it means that rupee is expected to become weaker, or depreciate. Rupee is expected to depreciate by |(0.009 - 0.010)/0.010| = 0.1 or 10%

Interest rate parity states that:

S_US/IN*(1 + i_US) = F_US/IN*(1 + i_IN) where S denotes the spot rate and F denotes the forward rate

So, 0.01*(1 + 0.05) = F*(1 + 0.15)

F = 0.0105/1.15 = 0.0091$/Re