The spot rate of the Australian dollar is $0.76, and the spot rate of the Britis

Question

The spot rate of the Australian dollar is $0.76, and the spot rate of the British pound is $1.32. You expect that the one-year inflation rate is 8 percent in the U.K., 5 percent in Australia, and 3 percent in the U.S. The one-year interest rate is 8% in the U.K., 6% in Australia, and 5% in the U.S. Assume that locational arbitrage and triangular arbitrage ensures that spot exchange rates are properly aligned. Also assume that you believe in the International Fisher Effect. What is your expected spot rate of the British pound in one year with respect to the Australian dollar?

Explanation / Answer

International Fisher Effect states that spot exchange rate should change to adjust for differences in interest rates between two countries.

Expected Spot Rate (USD/GBP) = Current Spot Rate (USD/GBP) x (1 + i(USD)) / (1 + i(GBP))  

= 1.32 x (1 + 5%) / (1 + 8%) = $1.2833 per pound

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