Question

1. a)Countries Australia and France have their interest rates to be 8% and 12 %, respectively. If their currencies trade according to 2 Australian $s buy one euro in the spot market, what will their future spot rate be in the aforementioned context? b) Define IFE and explain the fact of how it occurs. Is there any deviation from it?

Answer 1

a) Forward Rate= Current exchange rate *(1+ domestic rate)/(1+ foreign rate)

= 2*(1+.08)/(1+.12) = 1.9286

Thus, in the future 1.9286 AUD will buy one Euro.

b) International Fisher Theory states that an estimated change in the current exchange rate between any two currencies is directly proportional to the difference between the two countries nominal interest rates at a particular time.

It happens because the country with a higher interest rate, will see a higher inflation rate and will experience a depreciation of its currency.