If the spot rate for Swiss Francs versus US Dollars is one SF equals 1.1 US $, a
ID: 2805138 • Letter: I
Question
If the spot rate for Swiss Francs versus US Dollars is one SF equals 1.1 US $, and the annual interest rate on fixed rate one-year deposits of SF is 0.5% and for US$ is 2%, what is the nine-month forward rate for one dollar in terms of SF? Assuming the same interest rates, what is the 18-month forward rate for one SF in US$? Is this an indirect or direct rate? If the forward rate is an accurate predictor of exchange rates, in this case will the SF get stronger or weaker against the US dollar? What does this indicate about the market’s inflation expectations in Switzerland compared to the US?
Please answer fully and with good explanation. Not just equation and answer.
Explanation / Answer
Forward rate is the rate at which one currency is exchanged for another currency at a pre determined rate at a future date.
Nine month forward rate = [1 + (interest rate of Swiss Franc * 9/12)] / [1 + (interest rate of US Dollar * 9/12)]
= [ 1+ (0.5% * 9/12)] / [ 1+ (2% *9/12)]
= 0.25%
Eighteen month forward rate = [1 + (interest rate of Swiss Franc * 18/12)] / [1 + (interest rate of US Dollar * 18/12)]
= 0.25%
An indirect quote is the foriegn currency expressed in terms of the home currency. Indirect quote is 1/ Direct quote. A direct quote will typically seem like 1 $ = 0.8 Pounds
As the computed forward is lesser than the prevailing exchange rate at 0.25% when compare to 0.5%, the SF will get stronger. This means that fewer Swiss Francs will be requried to buy US dollars in case declining interest rates.
A currency gets stronger when people anitcipate the inflation levels to be lesser in the country . A low inflation rate attracts market investment and reduces differences in exchange rates.Therefore inflation in Switzerlans is expected to be lesser than inflation in US.
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