1. If the spot rate for British pounds is 0.57 pounds equals 1 US $, and the ann
ID: 1249745 • Letter: 1
Question
1. If the spot rate for British pounds is 0.57 pounds equals 1 US $, and the annual interestrate on fixed rate one-year deposits of pounds is 3.5% and for US$ is 2.5%, what is the
ten-month forward rate for one dollar in terms of pounds? Assuming the same interest
rates, what is the 18-month forward rate for one pound in dollars? Is this an indirect or a
direct rate? If the forward rate is an accurate predictor of exchange rates, in this case will the pound get stronger or weaker against the dollar? What does this indicate about the market’s inflation expectations in the UK compared to the US?
Explanation / Answer
According to the given information, Spot rate for $1 = 0.57 pounds Fixed interest rate for pounds = 3.5% Interest rate for US dollars = 2.5% Ten month forward rate is calculated as Forward exchange rate = Spot price * [(1+foreign interest rate) / (1 + Base interest rate)]^n = 0.57 * [ (1 + 0.035) / (1+0.025)]^(10/12) = 0.57 * [ 1.0097] ^0.833 = 0.57 * 1.0080 = 0.57456 Spot rate for $1 = 0.57 pounds 1 POund = $1.754 Forward exchange rate = $1.754 * [ (1 + 0.025) / (1+0.035)]^(18/12) = $1.754 * [ 0.99] ^1.5 = $1.754 * 0.985 = 1.7277 This is a direct rate because in quoting a foreign exchange rateit is quoted as the domestic currency per unit of the foreign currency. If the forward rate is an exact predictor of the exchange rate, then the pound will becomes stronger against dollars as for one pound it can get $1.754 dollars. Therefore, the pound appreciates against dollar. We know that there is an inverse relation between the currency exchange rate and the inflation rate. Here the pound became stronger and appreciates in value against dollar. For one pound we can buy 1.754 dollars. There fore, the purchasing power parity increases in UK and the prices of goods increases due to increased Purchasing power parity. Therefore, the inflation rate increases due to the increased prices. Hence the inflation rate increases in UK and decreases in US. Spot rate for $1 = 0.57 pounds 1 POund = $1.754 Forward exchange rate = $1.754 * [ (1 + 0.025) / (1+0.035)]^(18/12) = $1.754 * [ 0.99] ^1.5 = $1.754 * 0.985 = 1.7277 This is a direct rate because in quoting a foreign exchange rateit is quoted as the domestic currency per unit of the foreign currency. If the forward rate is an exact predictor of the exchange rate, then the pound will becomes stronger against dollars as for one pound it can get $1.754 dollars. Therefore, the pound appreciates against dollar. We know that there is an inverse relation between the currency exchange rate and the inflation rate. Here the pound became stronger and appreciates in value against dollar. For one pound we can buy 1.754 dollars. There fore, the purchasing power parity increases in UK and the prices of goods increases due to increased Purchasing power parity. Therefore, the inflation rate increases due to the increased prices. Hence the inflation rate increases in UK and decreases in US. = $1.754 * [ 0.99] ^1.5 = $1.754 * 0.985 = 1.7277 This is a direct rate because in quoting a foreign exchange rateit is quoted as the domestic currency per unit of the foreign currency. If the forward rate is an exact predictor of the exchange rate, then the pound will becomes stronger against dollars as for one pound it can get $1.754 dollars. Therefore, the pound appreciates against dollar. We know that there is an inverse relation between the currency exchange rate and the inflation rate. Here the pound became stronger and appreciates in value against dollar. For one pound we can buy 1.754 dollars. There fore, the purchasing power parity increases in UK and the prices of goods increases due to increased Purchasing power parity. Therefore, the inflation rate increases due to the increased prices. Hence the inflation rate increases in UK and decreases in US.Related Questions
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