Question

1. If the foreign interest rate is 15%, the current exchange rate is 10 and the expected future exchange rate is 11, what is the domestic interest rate according to the interest parity condition?

a. 25%

b. 14%

c. 11%

d. 10%

e. 5%

2. If the foreign interest rate is 5%, the current exchange rate is 4 and the domestic interest rate is 10%, what is the expected future exchange rate according to the interest parity condition?

a. 4.0

b. 4.2

c. 4.4

d. 4.6

e. 5.0

3. If inflation in Japan is 5% and in the U.S. it is 3%, then we would predict that the exchange rate (from the U.S. perspective) will:

a. fall by 5%.

b. fall by 3%.

c. fall by 2%.

d. rise by 2%.

e. rise by 8%.

Answer 1

According to Interest Parity theory

Future exchange rate = ( Spot exchange rate * 1+ domestic rate of interest ) / 1+ foreign rate of interest

1. a. 25 % 11 = 10* 1+ domestic rate of interest / 1.15

2. b. 4.2 Future exchange rate = 4*1.1 / 1.05

3. c. fall by 2%. - Since the inflation in Japan is more than the inflation in U.S. the exchange rate of U.S.D will become relatively favourable, lesser amount of dollars will have to exchanged for purchasing Yen.