Question

Suppose that the six-month interest rate in the United States is 5%, while the six-month interest rate in Britain is 8%. Further, assume the spot rate of the pound is 1.25. Given the spot rate of 1.25 of the pound, as well as the premium of -2.7778% that you calculated previously, the six month forward rate of pound should be about ___ under IRP.

Answer 1

To calculate the six-month forward rate of the British pound under Interest Rate Parity (IRP), the spot rate must be adjusted by the interest rate differential and the previously determined premium. With a spot rate of 1.25, a 5% interest rate in the US, an 8% rate in Britain, and a -2.7778% premium, the calculated six-month forward rate is approximately $1.2153.

Step-by-step explanation:

The student's question is seeking to apply the concept of Interest Rate Parity (IRP) to determine the six-month forward exchange rate of the British pound given the current spot rate and interest rates in the US and Britain. Under IRP, the forward rate is determined by adjusting the spot rate according to the interest rate differential between the two countries. Given the spot rate of 1.25 (1 British pound = $1.25), the six-month US interest rate of 5%, the British interest rate of 8%, and a previously calculated discount premium of -2.7778%, we can calculate the forward rate.

First, we find out the interest rate differential:
(British interest rate - US interest rate) / US interest rate = (8% - 5%) / (1 + 5%) = 3% / 1.05 approximates to 2.8571%. Then, we apply the discount or premium to adjust the spot rate:
Spot rate × (1 - Premium) =
1.25 × (1 - 0.027778) = 1.25 × 0.972222 = approximately $1.2153. Thus, the six-month forward rate of the British pound should be about $1.2153 under IRP.