Suppose that the US dollar interest rate and the Swiss Franc interest rate are t

Question

Suppose that the US dollar interest rate and the Swiss Franc interest rate are the same, 5 percent per year, but that there is a risk premium of 1 percent associated with holding Swiss Franc rather than US dollars over the year. (a) What is the relationship (in percentage terms) between the current equilibrium dollar/franc exchange rate and its expected future level? (b) If the expected future exchange rate is $1.12 per franc, what is the equilibrium dollar/franc (spot) exchange rate? Now suppose that the expected future exchange rate, $1.12 US per franc, remains constant as Swiss's interest rate rises to 10 percent per year. (c) If the US interest rate also remains constant, what is the new equilibrium dollar/franc exchange rate? only part c needs to be answered

Explanation / Answer

1 + i in swiss + risk premium/1 + i in U.S = F/S

[1 + 0.10 + 0.01]/[1+0.05] = 1.12/S

1.11/1.05 = 1.12/S

S = 1.12*1.05/1.11

S = $1.0594 US per franc

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