Question

3. (8 pts.) Today, the one-year T-bill rate is 4% in Canada and 6% in the US. The (expected) inflation rate for the next one year (Year 2019) is 2% in Canada. a) (4 pts.) Estimate the (expected) inflation rate next year in the US (Year 2019). b) (4 pts.) Estimate the one-year forward rate to be determined today (Fly, CSIS).

Answer 1

a)As per Interest rate parity theory,

1. (1+rD)/(1+rF) = Forward rate/Spot rate

where rD - Rate of interest in domestic country

rF - Rate of interest in foreign country

And as per purchasing power parity theory,

2. (1+iD)/(1+iF) = Forward rate/spot rate

Where iD - Inflation rate in domestic country

iF - Inflation rate in foreign country

By merging the above 1 & 2 points. We can arrive :

(1+rD)/(1+rF) = (1+iD)/(1+iF)

Now replacing the given values in above equation assuming canada is the home country. So D is canada and F is USA

(1+0.04)/(1+0.06) = (1+0.02)/(1+iF)

0.9811 = 1.02/(1+iF)

1+iF = 1.02/0.9811

1+iF = 1.0397

iF = 0.0397

So iF = 3.97%

i.e approximately inflation rate in USA is 4%

Note : even if we assume that USA is the home country and canada is foreign country the answer would be the same. Because of the equation.

b) since spot rate data is not available in the question, the forward rate could not be calcuĺated. But as per the interest rate parity theory, the interest rate differential is equal to the forward premium percent.

So the interest rate differential (6%-4%=2%) is the forward premium

I.e the forward premium is 2% and the forward rate would be spot+2%