Question

1. A U.S.-based Treasury risk manager is evaluating his EUR hedging program with the following information regarding the USD/EUR exchange rate and respective benchmark rates:

• Current USD/EUR exchange rate: 1.08

• Current USD 1-year risk-free interest rate: 0.45%

• Current EUR 1-year risk-free interest rate: -0.30%

Calculate the one-year forward USD/EUR exchange rate and explain whether based upon the interest rate differential the EUR is expected to appreciate or depreciate (8 points)

Answer 1

Interest Rate Parity Theory is given by

1+Rh / 1+Rf = F1/S0

where

Rh - Risk-free interest rate in home country = .45%

Rf - Risk-free interest rate in foreign country = .30%

F1 - 1 year forward rate =?

S0 - Spot RAte =1.08

1.0045/1.0030 = F1/1.08

F1/1.08 = 1.00149551346

F1 = 1.00149551346*1.08

= 1.0816

Here exchange rate is given in the format of  USD/EUR. Hence, USD(first currency) is the home country and EUR(second currency) is the foreign country.

IRPT states that high interest rate in a country is offset by depreciation in the currency of that country. So here USD should depreciate.

Here forward rate>spot rate. That is product in the exchange rate, EUR is appreciating and USD is depreciating, which is in line with IRPT.