Question

Interest rates in Turkey are currently 8.25% p.a. and in Germany interest rates are currently offered at a negative 0.5% p.a. The Euro currently trades at EUR/TRY 8.73. Given the current spot rate of EUR/USD 1.18 and an annualised forward premium of 0.85% p.a. for the EUR against the USD, generate a forecast of the value of the USD in terms of Turkish Lira (TRY) for 2 year’s time. Which equilibrium relationships are you using to generate this forecast? Show all workings.

Answer 1

Since the annual forward premium for EUR is 0.85%

Forward EUR/USD rate =1.18*1.0085 = 1.19003

As per Interest rate parity (IRP)

Forward rate / spot rate = (1+ interest rate in USA)/(1+ interest rate in Germany)

=> 1.19003/1.18 = (1+ interest rate in USA) / (1-0.005)

interest rate in USA =0.0034575 or 0.35% p.a.

Assuming no triangular arbitrage

Spot USD/TRY rate = 8.73/1.18 = 7.3983

Again from interest rate parity

Forecast of the value of the USD in terms of Turkish Lira (TRY) for 2 year’s time

ie. Forward Rate for 2 years = 7.3983*1.0825^2/1.0035^2 = 8.6097 or USD8.61/TRY