Assume that the one-year interest rate in the United Kingdom is 9 percent, ehie

Question

Assume that the one-year interest rate in the United Kingdom is 9 percent, ehie the one-year interest in the United States is 4 percent. The spot rate of the pound is $1,50. Assume that interest rateparity exists. The quoted one-year interest in the United Kindom is expected to rise consistently over the next month. Meanwhile, the quoted one-year interest rate in the United States is ecpected to decline consistently over the next month. Assume that the spot rate does not change over the month. Based on this information, how will the quoted one-year forward rate change over the next month?

Explanation / Answer

As we know Forward=Spot*(1+domestic)/(1+foreign)

Initially:

Spot USD/GBP

domestic USD rate=4%

foreign GBP rates=9%

Forward=Spot(1+4%*30/360)/(1+9%*30/360)

Forward=Spot*0.996

Later on:

As 4% would decrease and 9% would increase, so using above formula we can say that

Forward would decrease that is less USD/GBP or USD would appreciate and GBP would depreciate

Alternatively:

As per International Fisher effect, the country with higher interest rate should see depreciation in its currency because higher interest rates would mean higher inflation thus eroding the purchasing power of the currency.

Hence, currently, UK has high rate and US has low rate..Initially forward would be priced in favor of US because of the above reason. Gradually, as interest rates in UK rise and interest rates in US decline, UK's currency would depreciate due to rising interest rates in UK and also because of US appreciating due to declining interest rates..So, forward would move in favor of US.

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