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 .PESO should be at a forward discount of 2% approximately or 2/ 1.10= 1.818% against $.

b. Since there is no difference in interest rate, forward rate should trade at par against dollar.

c.Since Peso is at forward discount in year 1, Peso will depreciate.

d. The exchange rate will remain same from end of first year to second year as there is no premium or discount in forward rate.

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