Question

Due to the integrated nature of their capital markets, investors in both the United States and the U.K. require the same real interest rate, 29 percent, on their lending. There is a consensus in capital markets that the annual inflation rate is likely to be 3.9 percent in the United States and 19 percent in the U.K. for the next three years. The spot exchange rate is currently $1.9/£.

a. Compute the nominal interest rate per annum in both the United States and the U.K., assuming that the Fisher effect holds. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

b. What is your expected future spot dollar-pound exchange rate in three years from now? (Do not round intermediate calculations. Round your answer to 4 decimal places.)

c. Can you infer the forward dollar-pound exchange rate for one-year maturity? (Do not round intermediate calculations. Round your answer to 4 decimal places.)

Answer 1

a. The nominal interest rate in the United States is 32.9% and in the U.K is 48%, b. The expected future spot dollar-pound exchange rate in three years is $1.8579/£, c. The forward dollar-pound exchange rate for one-year maturity cannot be inferred.

Step-by-step explanation:

a. To compute the nominal interest rate per annum in both the United States and the U.K, we can use the Fisher effect formula. The Fisher effect states that the nominal interest rate is equal to the sum of the real interest rate and the expected inflation rate. For the United States, the nominal interest rate would be 29% + 3.9% = 32.9%. For the U.K, the nominal interest rate would be 29% + 19% = 48%.

b. To calculate the expected future spot dollar-pound exchange rate in three years from now, we need to consider the difference in inflation rates between the two countries. Using the formula (1 + inflation rate of one country) / (1 + inflation rate of another country), we get (1 + 3.9%) / (1 + 19%) = 0.9785. Multiplying this by the spot exchange rate of $1.9/£, we get an expected future spot rate of $1.8579/£.

c. The forward exchange rate can be calculated using the formula F = S * (1 + i) / (1 + j), where F is the forward rate, S is the spot rate, i is the interest rate of the base currency, and j is the interest rate of the quote currency. Since we don't have the interest rates for one-year maturity, we cannot determine the forward exchange rate.