Question

The spot rate in the $/euro is .7 $/euro. What will the expected spot rate be, if the interest rates in the s and the euro are .04 and .09 respectively? Show both dollar and euro terms. Explain the meaning of your results. Does the aforementioned relate to inflation differences between the two currencies?

Answer 1

Here we use the interest rate parity formula to calculated the expected spot rate or the forward rate

As per interest rate parity,

F = S * ((1 + i_f) / (1 + i_d)) where S = .07 $/Euro, if =0.09 and id = 0.04

F = 0.07 *(1.09/1.04) = 0.073365

So, Expected spot rate = 0.073365$/Euro or 0.0734$/Euro (Rounded to 4 decimals)

The meaning is that The interest rate in Europe is higer and hence the Euro will depreicate against the dollar. In other words, dollar is expected to appreicate.