1. Interest Rate Parity, Purchasing Power Parity, Interruidonal Fisher Effect
Separated by more than 1,000 nautical miles and five time zones, money and foreign exchange markets in both Loo and New York are very efficient The following information has been collected ftom the respective areas:
|
Assumption
|
London
|
NewYork
|
|
Stock Exchange rate($/pound)
|
1.3264
|
1.3264
|
|
One-year treasury bill rate
|
2.900%
|
2.500%
|
|
Expected inflation rate
|
Unkown
|
1.250%
|
a. Estimate todays one-year forward exchange rate F between the dollar and the pound using Covered Interest Rate Parity.
b. Find approximate expected inflation in London next year. Is it smaller or larger than New York expected inflation? Why?
You can do the forecast using PPP or International Fisher Effect. If you use PPP then assume that the Expected exchange rate E(S) is the same as the forward exchange rate F that you found in (a). Then solve for expected inflation in London using PPP formula. If you use International Fisher effect assume that the real interest rates for two countries are the same.
2. Speculation In the Forward Market.
The current spot exchange rate is 51.951 and the three-month forward rate is SI.90/L. Based on your analysis of the exchange rate, you are pretty confident that the spot exchange rate will be $1.921L in three months. Assume that you would like to buy or sell LI,000,000.
a What actions do you need to take to speculate in the forward market? What is the expected dollar profit from speculation?
b. What would be your speculative profit in dollar terms if the spot exchange rate actually turns out to be S1.861E.