Question

Suppose the spot exchange rate for the Hungarian forint is HUF 223. Interest rates in the United States are 3.4 percent per year. They are 5.3 percent in Hungary. Use the approximate interest rate parity equation to answer this question. What do you predict the exchange rate will be in one year? In two years? In five years? (Do not include the Hungarian forint sign (HUF). Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)

Answer 1

Using the approximate version of the interest rate parity, we have:

F(h/f) = S(h/f)*(ih - if) + S(h/f) where

F(h/f) = forecasted exchange rate

S(h/f) = spot exchange rate = 223 HUF/$; ih = home country interest rate (in this case, Hungary) = 5.3%; if = foreign country interest rate (in this case, US) = 3.4%

Year 1 forecasted exchange rate = 223*(5.30%-3.40%) + 223 = 227.34

Year 2 forecasted exchange rate = 227.34*(5.30%-3.40%) + 227.34 = 231.55

Year 5 forecasted exchange rate = 240.44*(5.30%-3.40%) + 240.44 = 245.01