15. (8pts) US one year interest rate is 6% annual and EU one year interest rate

Question

15. (8pts) US one year interest rate is 6% annual and EU one year interest rate is 8% annual. Currently the spot rate in the market is $1.12/Euro. According the International Fisher Effect, what is your prediction about the value of euro against USS after one year Calculate the future spot rate in a year and justify your answer based on the theory. 16, (8pts) If the inflation rate in the UK is higher than the inflation in the US. by 2%, the relative PPP theory would predict that the British pound would against USS by %. (Long term) 17. (8pts) A company decides to set up a call option contract to cover its BP 00 re (British Pound Payables) in 9 d u 0TC

Explanation / Answer

15.

Fisher effect is an economic theory which describe the relationship between nominal interest rate and Inflation rate. Real Interest rate is calculated by subtraction of inflation from nominal Interest rate.

Forward rate according to fisher effect is calculated below:

Forward rate = Spot Rate × (1 + EU rate) / (1 +US rate)

= $1.12 × (1 + 8%) / (1 + 6%)

= $1.12 × 1.0189

= $1.1411

Forward rate according to fisher effect is $1.1411.

16.

If inflation rate in UK is higher than inflation rate in US by 2% then currency of UK that is Brithish pound would depreciate against dollar by 2.04% .

Percentage depreciation = 2% / (1 - 2%)

= 0.2 / .98

= 2.04%

British pound would depreciate by 2.04%.

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