Question

- The U.S nominal annual rate of interest is 5% and the Malaysian annual nominal rate of interest on the Ringgit is 13%. At the same time, the spot exchange rate is 3 MYR per USD and the real rate is 2% in both the US and Malaysia.

- What is the one year forecast of the MYR per USD spot exchange rate, assuming the International Fisher effect holds?

- Describe the potential problem with your forecast in part A. If you determined that Malaysia has a 4% country risk premium impounded in its interest rate, how would this change your forecast? (SHOW).

Answer #1

As per the Internation Fisher efffect the difference in nominal interest rates is proportional to difference in exchange rates between the two currencies. As per the model,

One year forcast = Spot exchange rate * ( 1 + foreign int rate ) / ( 1 + domestic int rate )

= 3 * 1.13/ 1.05

= 3.5595

One year forecast of the MYR /USD = **3.56 MYR /
USD**

The major problem here is that we have predicted that MYR will depreciate against USD after 1 year. But the MYR can appreciate against USD.

If malaysia has 4% country risk premium we shall remove teh same from the interest rate of MYR ie the revised nominal interest rate = 13 - 4 = 9 %

Revised One year forcast= 3 * 1.09 / 1.05 = **3.11 MYR
/USD**

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