IFE and Forward Rate. The one-year Treasury (risk-free) interest rate in the U.S
ID: 2784580 • Letter: I
Question
IFE and Forward Rate. The one-year Treasury (risk-free) interest rate in the U.S. is presently 6%, while the one-year Treasury interest rate in Switzerland is 13%. The spot rate of the Swiss franc is $.80. Assume that you believe in the international Fisher effect. You will receive 1 million Swiss francs in one year.
a. What is the estimated amount of dollars you will receive when converting the francs to U.S. dollars in one year at the spot rate at that time?
b. Assume that interest rate parity exists. If you hedged your future receivables with a one-year forward contract, how many dollars will you receive when converting the francs to U.S. dollars in one year?
Explanation / Answer
a.
Notional Principle = 1,000,000 Franc
Spot rate = $0.80 per franc
Total Dollar receive = 1,000,000 × $0.80
= $800,000
Total dollar receive if amount converting at Spot rate is $800,000.
b.
Interest rate parity exists then Forward exchange rate is calculated below:
Forward rate = Spot rate × (1 + US rate) / (1 + Switzerland Rate)
= $0.80 × (1 + 6%) / (1 + 13%)
= $0.80 × 0.9381
= $0.7504
Forward rate is $0.7504 per Franc.
So, total Dollar receive after one year = 1,000,000 × $0.7504
= $750,442.48.
So, total Dollar receive after one year will be $750,442.48.