Need help with finance class, dealing with fisher effect and parity. INTEREST RA
ID: 1172816 • Letter: N
Question
Need help with finance class, dealing with fisher effect and parity.
INTEREST RATE PARITY, PURCHASING POWER PARITY AND INTERNATIONAL FISHER EFFECT Assume the following information is available for the US and Europe: U.S. Nominal interest rate (ih and if) for ease of notation in Excel, that subscripts aren't used here Expected inflation (lh and If) Spot rate One-year forward rate Europe 6% 5% $1.13 $1.10 4% 2% a. Does IRP hold? b. According to PPP, what is the expected spot rate of the euro in one year? c. According to the IFE, what is the expected spot rate of the euro in one year? d. Reconcile your answers to parts (a). and (c using i RP, Forward premium (p)-(1 + ih)/(1 + if)-1 Expected forward rate for the euro spot rate1p) expected spot rate in one year spot rate1 ef expected spot rate in one year spot rate1 ef b Using PPP, expected spot rate in one year ef (1h(1+If)-1 c Using IFE, expected spot rate in one year ef(11if)-1Explanation / Answer
(a) Using IRP, Forward Premium = [(1.04)/(1.06) - 1] = - 0.0189
Expected forward rate for Euro = 1.13 x (1-0.0189) = $ 1.1087 approximately
Hence, IRP is not strictly applicable.
(b) Using, PPP , expected spot rate = [(1.02 / 1.05) x 1.13] = $ 1.0977 approximately.
(c) Using IFE, the expected spot rate = [(1.04/1.06) x 1.13] = $ 1.1087 approximately.
(d) The answers using PPP and IFE are different because of the fact that interest rates used are nominal interest rates(not adjusted for inflation) instead of real interest rates. Further, factors determining interest rates and inflation though similar and closely linked are not exactly the same, thereby impacting exchange rates to varying extents.
Further, for IRP(also IFE) to hold the forward rate of $ 1.1 has to converge to the expected spot rate and expected forward rate of $ 1.1087 with the expected spot rates and expected forward rates themselves converging with each other in an ideal world.