9. Assume interest rate parity holds. Today the US one-year interest rate is 8%

Question

9. Assume interest rate parity holds. Today the US one-year interest rate is 8% and the annualized two-year interest rate is 11%. Mexico’s one-year interest rate is 10% and its annualized two-year interest rate is 11%.

a. What is the forward exchange rate premium (in terms of dollars per peso) for one year ahead?

b. What is the forward exchange rate premium for two years ahead?

c. If you use the forward rates to forecast the future spot rates, will the peso appreciate or depreciate from now until the end of year two?

d. If you use the forward rates to forecast the future spot rates, will the peso appreciate or depreciate from the end of year one until the end of year two?

Explanation / Answer

a) Forward Rate = Spot Rate x ((1 + US rate) / (1 + Mexican rate))^n

1-year forward rate = Spot Rate x ((1 + 8%) / (1 + 10%))^1 = 0.9818 x Spot Rate

Premium or Discount = (F - S) / S = (0.9818 S - S) /S = -0.01818 USD/peso

b) 2-year forward rate = Spot Rate x (1.11/1.11)^2 = Spot Rate

Hence, there is no premium or discount for two years ahead.

c) Over the next two years, the peso would remain constant.

d) For the first year though, the peso would depreciate and over the second year, it would appreciate.

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