Question

Current spot rate of SF = $0.6543; 1-year interest rate in the U.S. = 7.5%; 1-year interest rate in the Switzerland = 3.5% If one year later, the spot rate for SF turns out to be $0.6625, according to IFE, would SF be overvalued or undervalued in real terms?

a. Overvalued

b. Undervalued

calculation and explanation!!!

Answer 1

Spot rate 1 SF	$ 0.6543
Interest rate in US	7.5%
Interest rate in Switzerland	3.50%
Forward rate formula = Sport rate * (1 + U.S. interest rate)^n / (1+ Swis. interest rate)^n
Forward rate = 0.6543 * (1+0.075/(1+0.035)
$0.6796
Theoritical forward rate is 1 SF = $0.6796
While actual forward rate is 1 SF = 0.6625
It means SF is undervalued in real terms.As per interest rate parity theory, price of 1 SF should be equivalent to $ 0.6796
But in real terms, it is only $0.6625. We can buy less dollar for SF in comparison to theoritical price. So SF value is kess than theoritical price.
So, it is undervalued in real terms.