Question

1. 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.

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

2. 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