Money and foreign exchange markets in Japan and Swiss are quite efficient. You h

Question

Money and foreign exchange markets in Japan and Swiss are quite efficient. You have the following information:

Japan Germany

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Spot exchange rate ¥100/DM SF0.01/¥

Expected inflation rate 2% per annum 5% per annum

One-Year ‘T-bll’ rate Unknown 8% per annum

a. What is you estimate of the one-year T-bill rate in Japan?

b. What is your estimate of the one-year forward exchange rate between Japanese yen and SF?

c. What is your best estimate of the one-year future spot exchange rate between Japanese yen and SF?

Explanation / Answer

1 As per international fishers effect - Real interest rate in one country A = Real interest rate in country B 1+ia/1+ra = 1+ib/1+rb          …..(i) From given info - Let A = germany B = Japan ia = 0.08 ra=0.05 ib= let x rb=0.02 Putting in equation 1 1+x/1.02 = 1.08/1.05 1+x = 1.08 x 1.02/1.05 x=4.9143% one year t-bill rate in japan should be = 4.91% 2 Forward exchange rate can be determined using Interest rate parity F/S= 1+ia/1 +ib SF/yen = 0.01        ….Spot Therefore putting in equation.. F/0.01 = 1.08/1.049143 F= 0.0103 3 Estimated spot rate is given by Expectation form of purchasing power parity E(s)/s = 1+ra/1+rb e(s) = (1+ra x s)/1+rb e(s) = 1.05x0.01/1.02 0.010294 Please provide feedback…. Thanks in advance….:-)

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