5. 15 points. Below is information on interest rates, inflation rates, and a spo

Question

5. 15 points. Below is information on interest rates, inflation rates, and a spot and 1-year forward exchange rate for the US dollar and the British Pound Interest rate (1-yr Inflation rate (consumer prices, Interbank Spot Forward rate(1- yr) 1.3363 bond) latest) rate USD 2.7641% 1 GBP $1.3134 USD +2.8% GBP 0.9612 % +2.4% interest rates are. LIBQR int all accessed July 2, 2018) erbank rates; exchange and forward rates from Investing.com; Inflation rotes from The Economist a.) determine the future expected spot rate that would be predicted to apply in 1 year by Uncowered Interest Parity. What would UIP predict to happen to the relative value of the dollar over the next year? b.) determine the future expected spot rate that would be predicted to apply in 1 year by Purchasing Power Parity. What would PPP predict to happen to the relative value of the dolilar over the next year? c) For each prediction, is the prediction a good fit for the actual forward rate indicated above? Based on your theoretical understanding of UIP and PPP (and their limitations), discuss possible reasons for any deviation of the market forward rate from the values predicted in (a) and (b). 12 700 Words English (US)

Explanation / Answer

1(A) The relative value of the dollar would decrease due to high interest rates in US.

1(B) The relative value of the dollar would diminish over the years.

The difference in Inflation = 2.8 - 2.4 = .4.
So the Inflation in US is higher than Britain. So going forward Exchange rate as per PPP would be higher in Britain.
Forward exchange rate of 1GBP as per PPP = (1.3134)(1.004) = 1.3186

1(c) The rates calculated above are diffrent from the forward rates shown above. The reason is that the above interest rates are as per inflation & interest rates. Inflation & interest rates can change over time so these calculations might not hold true. Inspite of low interest rates , the currency can fall because of safer heavens.  

Interest rates that would prevail in US (1.027641)(1.028) = 1.0564 Interest rates that would prevail in Britain (1.009612)(1.024) = 1.0338 the diffrence in interest rates between US & Britain = 1.0564-1.0338 = .0226%. So Exchange rates in Britain would appreciate by .0226%. Spot 1 GBP = $1.3134 UIP = $1.3134*(1.000226) = 1.31369

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