Assume the following information is available for the U.S. and Europe: U.S. Euro

ID: 2776772 • Letter: A

Question

Assume the following information is available for the U.S. and Europe:

U.S.

Europe

Nominal interest rate

Expected inflation

Spot rate

-----

$1.13

One-year forward rate

-----

$1.10

Does IRP hold?

According to PPP, what is the expected spot rate of the euro in one year?

According to the IFE, what is the expected spot rate of the euro in one year?

Reconcile your answers to parts (a). and (c).

U.S.

Europe

Nominal interest rate

Expected inflation

Spot rate

-----

$1.13

One-year forward rate

-----

$1.10

Real Interest rates in US = 1.05 / 1.03 = 1.0194 i.e. 1.94%

Real Interest rates in US = 1.07 / 1.05 = 1.0190 i.e. 1.90%

As per IRP, expected spot rate of euro in one year = 1.13 * 1.94 / 1.90 = $ 1.13. One year forward rate available is $1.10. Hence IRP does not hold.

As per PPP, expected spot rate of euro in one year = 1.13 * 1.03 / 1.05 = $ 1.11

As per IFE, expected spot rate of euro in one year = 1.13 * 1.05 / 1.07 = $ 1.11

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