Question

Problem 17-02 Interest Rate Parity The nominal yield on 6-month T-bills is 4%, while default-free Japanese bonds that mature in 6 months have a nominal rate of 5%. In the spot exchange market, 1 yen equals $0.007. If interest rate parity holds, what is the 6-month forward exchange rate? Round the answer to five decimal places. Do not round intermediate calculations. $

Answer 1

Forward exchange rate / Spot exchange rate = (1 + rh) / (1+rf)

where, rf is the default free interest rate

rh is the interest rate of the home country

rf = 5%/2 = 2.50% (Because 180 days is one-half of 360-day year)

rh = 4%/2 = 2% (Because 180 days is one-half of 360-day year)

Given that the spot exchange rate is $0.007

Substituting the values in the above equation, we get

Forward exchange rate / $0.007 = (1 + 0.02) / (1 + 0.025)

Forward exchange rate = [(1.02) / (1.025)] * $0.007 = 0.9951 * $0.007 = $0.00697

Therefore, the forward exchange rate (ft) = $0.00697