Question

Suppose the spot and three-month forward rates for the yen are 79.12 and 78.64 respectively, what would you estimate is the difference between the annual inflation of the United State and Japan

Answer 1

The estimated difference in annual inflation between the U.S. and Japan can be determined by applying the International Fisher Effect to the spot and forward exchange rates of the yen. The calculation suggests an approximate difference of 2.44%, indicating Japan may have a lower inflation rate compared to the U.S.

Step-by-step explanation:

The student is asking about the difference in annual inflation between the United States and Japan based on the spot and three-month forward rates for the Japanese yen. To estimate the difference in inflation rates using the given exchange rates, one can apply the International Fisher Effect (IFE) which assumes that the exchange rate changes are primarily determined by differential interest rates, which in turn, reflect expected inflation differences.

Here's a step-by-step explanation:

1. Calculate the forward premium or discount by comparing the spot and forward rate: (Spot Rate - Forward Rate) / Spot Rate.
2. Annualize the forward premium or discount: (Forward Premium Or Discount) x (12 / Number of Months in Forward Rate).
3. The result approximates the expected difference in annual inflation rates between the two currencies.

Using the spot rate of 79.12 yen/dollar and a forward rate of 78.64 yen/dollar, we have:

Forward Premium/Discount = (79.12 - 78.64) / 79.12 = 0.0061 or 0.61%

Annualized (since it's a three-month rate): 0.61% x (12 / 3) = 2.44%

This suggests that the expected difference in annual inflation rates between the U.S. and Japan is approximately 2.44%, with Japan potentially having the lower inflation rate assuming the Japanese yen appreciates against the U.S. dollar.