Question

The country of Daytona, whose currency is the U.S. dollar and the country of Prescott have the same real interest rate of 3 percent. The expected inflation over the next year is 6 percent in Daytona versus 21 percent in Prescott. The one-year currency futures contract on Prescott’s currency (called the pres) is priced at $.30 per pres.

What is the spot rate of the pres assuming interest rate parity holds?

Estimate the expected profit or loss if an investor sold a one-year futures contract today on one million Canadian dollars and settled this contract on the settlement date. Information for the contract is as follows:

PPP exists

Canadian inflation next year expected to be 3 percent

United States inflation next year expected to be 8 percent

Spot rate for Canadian dollar is $0.90

One year futures contract for Canadian dollar is priced at $0.87

New York Co. has agreed to pay 10 million Australian dollars (A$) in two years for equipment that it is importing from Australia. The spot rate of the Australian dollar is $.65. The annualized U.S. interest rate is 4 percent regardless of the debt maturity. The annualized Australian dollar interest rate is 12 percent regardless of the debt maturity. New York plans to hedge its exposure with a forward contract that it will arrange today. Assume that interest rate parity exists.

Determine the amount of U.S. dollars that New York Co. will need in 2 years to make its payment.

Answer 1

(1) Daytona Real Interest Rate = Prescott Real Interest Rate = 3 %

Daytona Inflation Rate = 6 % and Prescott Inflation Rate = 21 %

Daytona Nominal Interest Rate = R(d) = [(1+Real Interest Rate) x (1+Inflation)] - 1 = (1.03) x (1.06) - 1 = 1.0918 - 1 = 0.0918 or 9.18 %

Prescott Nominal Interest Rate = R(p) = [(1+Real Interest Rate) x (1+Inflation)] - 1 = [(1.03) x (1.21)] - 1 = 0.2463 or 24.63 %

Futures Exchange Rate = $ 0.3 / Pres

Let the current exchange rate be $K per Pres

Therefore, as per interest rate parity: K x [1+R(d) / 1+R(p)] = $0.3 / Pres

K = 0.3 x [1.2463/1.0918] = $ 0.342 per Pres

NOTE: Please raise separate queries for solutions to the other unrelated questions.