Assume the Hong Kong dollar (HK$) value is tied to the U.S. dollar and will rema
ID: 2796919 • Letter: A
Question
Assume the Hong Kong dollar (HK$) value is tied to the U.S. dollar and will remain tied to the U.S. dollar. Assume that interest rate parity exists. Today, a euro (€) is worth $1.50 and HK$7.10. The one-year interest rate on euro is 2%, while the one-year interest rate on the U.S. dollar is 7%. You believe in the International Fisher effect.
Boston company will receive €4 million in one year from selling products to Europe, and will convert these proceeds into Hong Kong dollars in the spot market at that time to purchase imports from Hong Kong.
Estimate the amount of U.S. dollars that Boston will receive in one year when converting its € receivables into U.S. dollars. (1.25 Points)
Forecast the amount of Hong Kong dollars that Boston will be able to purchase in the spot market one year from now with €4 million. (1.25 Points)(Hint: Since HK$ is pegged to USD, the value change between € and HK$ one year later is going to be exactly the same as that between USD and €)
Explanation / Answer
The constant in this case is the USD/HKD rate which is 7.10/1.50 = 4.7333
So, even one year later, this differential will remain the same.
Using interest rate parity, we can calculate the one-year forward rate as follows:
Forward EUR/USD = Spot rate * (1+interest rate of variable)/(1+interest rate of base)
In this case the variable is the USD and the base is the EUR
Forward rate = 1.5 * (1+0.7)/(1.02)
= 1.5735
After one year the amount of USD that could be received on EUR 4m would be 4 * 1.5735 = USD 6.294m
Similarly, using the USD/HKD constant rate, we can calculate the HKD as 6.294 * 4.7333 = HKD 29.79m