Question

1. You are given the following information. The Japanese currency is called the yen. The Korean currency is the won. The current nominal interest rate for a 1-year yen deposit in a Japanese bank is 1% (0.01), and it is 5% (0.05) for a deposit in a Korean bank. - The current spot exchange rate between the Japanese yen and Korean won (yen/won) is 100 that is one hundred yen to purchase one won. Answer the following questions. Make clear your assumptions and show your calculations. You can take Japan as the home country.

a) What is the expected exchange rate (yen/won) for one year from now?

b) What is the forward exchange rate?

c) Which country has the higher real interest rate?

Answer 1

Solution A

Expected future exchange rate is forward exchange rate after 1 year. Which is 96.19 yen by won.

Solution B

Forward exchange rate= spot exchange rate×(1+ domestic interest rate) /(1+foreign interest rate) =100×1.01/1.05= 96.19

Solution C

Real interest rate= Nominal Interest rate - inflation

Hence if we keep inflation being constant in both countries then real interest rate will be higher for country which nas higher nominal interest rate that is Korea which has 5% nominal Interest rate.