Problem 20-12 Spot versus Forward Rates Suppose the spot and three-month forward

Question

Problem 20-12 Spot versus Forward Rates

Suppose the spot and three-month forward rates for the yen are ¥79.50 and ¥78.88, respectively. What would you estimate is the difference between the annual inflation rates of the United States and Japan? (Negative amount should be indicated by a minus sign. Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places (e.g., 32.16).)

Inflation rate differential %

Please give step by step so I am able to learn how to calcualte. Thank you!

Explanation / Answer

First, we have to calculate the forward premium or discount on yen.

Forward premium = (Forward rate - spot rate) / spot rate

= (78.88 - 79.50) / 79.50

= -0.0077987421383 or -0.77987421383%

Differential interest rate = (1-0.0077987421383) x 4 - 1 = 2.969 or 29.69%

Inflation rate differential = 29.69% annually

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