Question

Suppose that the one-year interest rate on a US deposit is 8% and the interest rate on a EU deposit is 10%.  

1. If the spot rate is USD 1.30/EUR, then what should you expect the exchange rate between USD and EUR to be a year from now if you are indifferent between the EU and the US deposit?
2. What is the expected rate of appreciation/depreciation? (You may assume that you have $100 to invest).

Answer 1

We need to calculate the expected rate between USD and EUR 1 year from now using the forward rate formula:

where the currency is given in the form of A/B.

Here, the currency rate is given in the form of USD/EUR.

Therefore, Forward rate = (1.08/1.10) * 1.30

= USD 1.2764/EUR

Therefore the Euro is expected to be at a forward discount.

Therefore the rate of depreciation is approx 2% which is the same as the interest rate differential.

Given the above analysis, you may carry out a process using the $100 to be borrowed in US and invested in Euro.