Question

We know that the yen and the swiss franc have a 120yen/ sf 1 exchange rate, meaning one swiss franc buys 120 yen in the spot ER market. If the swiss franc has an interest rate of .06 and the yen rate is -.02, what is the forward exchange rate for IPT (interest parity theory) to be attained? Show everything in yen terms, i., e., how much yen one Swiss franc buys (yen is in the numerator.) If there is no equilibrium initially, will there be equilibrium eventually? If so, what will transpire?

Answer 1

As per IPT, the forward rate F_(Yen/CHF) = Spot rate_(Yen/CHF)*(1+Interest rate_Yen)/(1+Interest rate_CHF)

= 120*(1-0.02)/(1+0.06) = 110.94 Yen/CHF

Eventually the equilibrium rate has to be achieved otherwise there will be an arbitrage opportunity so the market will come to the equilibrium rate. As the IRP predicts, the currency with the higher interest rate will depreciate (the CHF depreciates) and the currency with the lower interest rate will appreciate (as does the Yen) to finally settle at the equilibrium rate.