Question

The interest rate in the U.K. is 3%, while the interest rate in the U.S. is 5%. The spot rate for the British pound is $1.50. According to the international Fisher effect (IFE), the British pound should adjust to a new level of:

		$1.47.
		$1.53.
		$1.43.
		$1.57.

Answer 1

Solution:

As per the International Fisher effect

Exchange rate differential = Interest rate differential

( Forward Rate / Spot Rate ) = [ ( 1 + Interest Rate in Home Currency ) / ( 1 + Interest Rate in Foreign Currency ) ] ⁿ

Where n = No. of years

As per the Information given in the question we have

U.S. Interest rate = 5 % = 0.05

U.K. Interest rate = 3 % = 0.03

Spot rate of the British Pound = $ 1.50

Thus $ / £ = $ 1.50

n= 1

Applying the above values in the formula / Equation we have

Forward Rate / $ 1.50 = [ ( 1 + 0.05 ) / ( 1 + 0.03 ) ] ¹

Forward Rate = [ 1.05 / 1.03 ] * $ 1.50

Forward Rate = [ 1.0194 ] * $ 1.50

Forward Rate = $ 1.5291

Forward Rate = $ 1.53 ( when rounded off to two decimal places )

Thus, According to the international Fisher effect (IFE), the British pound should adjust to a new level of $ 1.53

Thus the solution is Option 2 . $ 1.53