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You reside in the U.S. and are planning to make a one-year investment in Italy during...

You reside in the U.S. and are planning to make a one-year investment in Italy during the next year. Since the investment is denominated in euros, you want to forecast how the euro’s value may change against the dollar over the one-year period. You expect that Italy will experience an inflation rate of 3% during the next year, while all other European countries will experience an inflation rate of 7% over the next year. You expect that the U.S. will experience an annual inflation rate of 2% during the next year. You believe that the primary factor that affects any exchange rate is the inflation rate. Based on the information provided in this question, will the euro appreciate, depreciate, or stay at about the same level against the dollar over the next year? Explain.

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Answer #1

Expected forward rate = Spot rate *(1 + Inflation rate of home country)/(1+Inflation rate of foreign country

Here U.S. Is home country. Inflation rate = 2% annual

Italy is foreign country, inflation rate Of italy = 3% Annual

Assume Spot rate is 1Euro = 1.5 dollar

Expected forward rate = 1.5*(1+0.02)/(1+0.03)

1Euro = $1.48543689320388

At spot rate we could buy $1.5 for 1 Euro. Now at forward rate we could buy only $1.4854 against 1 Euro. It means value of Euro has deppreciated in comparison to spot rate.

So, Euro will depreciate against the dollar.

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