Question

The spot exchange rate between the Mexican peso (MXN) and the euro (EUR) is S0(MXN/EUR) = MXN 24.00/EUR. Eurocurrency interest rates are i(EUR) = 2% and i(MXN) = 8% per year. What should be the two-year forward exchange rate F2(MXN/EUR)?

Answer 1

Solution :

As per the Interest Rate Parity model

Exchange rate differential = Interest rate differential

Thus

( Forward Rate / Spot Rate ) = [ ( 1 + Interest Rate in Currency A ) / ( 1 + Interest Rate in Currency B ) ] ⁿ

Where n = No. of years ;

As per the Information given in the question we have

Mexican Interest rate i (MXN) = 8 % = 0.08 ( Currency A ) ;

Euro interest rate i (EUR) = 2 % = 0.02 ( Currency B )   ; n = 2 years ;

Spot rate of the Euro is 24.00 Mexican Peso

Thus S0 = MXN / EUR = ( A /B ) = 24.00 MXN

Applying the above values in the formula we have

Forward Rate / 24.00 = [ ( 1 + 0.08 ) / ( 1 + 0.02 ) ] ²

Forward Rate / 24.00 = [ 1.08 / 1.02 ] ²

Forward Rate / 24.00 = [ 1.058824 ] ²

Forward Rate / 24.00 = 1.121107

Forward Rate = 1.121107 * 24.00

Forward Rate = 26.906574

The two-year forward exchange rate F2(MXN/EUR) is

= 26.9066 MXN ( when rounded off to four decimal places )

= 26.91 MXN ( when rounded off to two decimal places )

Note : The value of ( 1.058824 ) ²   has been calculated using the excel function =POWER(Number,Power). Thus ( 1.058824 ) ²   = POWER(1.058824,2) = 1.121107