The 1-year interest rate on Swiss francs is 5 percent and the dollar interest rate is 8 percent.
(A) if the current $/SF spot rate is $0.60, what would you expect the spot rate to be in 1 year.
(B) Suppose US policy changes and leads to an expected future spot rate of $0.63. What would you expect the dollar interest rate to be now? ( assume no change in Swiss interest rate)
To answer these questions, we need to use the concept of interest rate parity, which states that the difference in interest rates between two currencies should equal the difference in their forward exchange rates. We can use this concept to calculate the expected future spot rate and the expected dollar interest rate.
(A) To calculate the expected future spot rate, we can use the interest rate parity formula:
F = S * [(1 + rdom) / (1 + rfor)]
Where:
F = forward exchange rate
S = current spot exchange rate
rdom = dollar interest rate
rfor = Swiss franc interest rate
In this case, the current $/SF spot rate is $0.60, the dollar interest rate is 8%, and the Swiss franc interest rate is 5%. Let's plug these values into the formula:
F = $0.60 * [(1 + 0.08) / (1 + 0.05)]
F = $0.60 * (1.08 / 1.05)
F = $0.60 * 1.02857
F = $0.61714
Therefore, we would expect the spot rate to be $0.61714 in 1 year.
(B) Now, let's calculate the expected dollar interest rate given an expected future spot rate of $0.63:
F = S * [(1 + rdom) / (1 + rfor)]
We know that S = $0.62, F = $0.63, and rfor = 5%. Let's rearrange the formula to solve for rdom:
rdom = [(F / S) * (1 + rfor)] - 1
Plugging in the values, we have:
rdom = [($0.63 / $0.62) * (1 + 0.05)] - 1
rdom = (1.0161290322580645 * 1.05) - 1
rdom = 1.0169354838709676 - 1
rdom = 0.0169354838709676
Therefore, the expected dollar interest rate would be approximately 1.69%.