Question

Casper Landsten-CIA (A). Casper Landsten is a foreign exchange trader for a bank in New York. He has $0.95 million (or its Swiss franc equivalent) for a short term money market investment and wonders if he should invest in U.S. dollars for three months, or make a CIA investment in the Swiss franc. He faces the following quotes: The CIA profit potential is %, which tells Casper Landsten he should borrow and invest in the yielding currency, the in order to earn covered interest arbitrage (CIA) profits. (Round to three decimal places and select from the drop-down menus.) 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, 2.5 percent, on their lending. There is a consensus in capital markets that the annual inflation rate is likely to be 3.5 percent in the United States and 1.5 percent in the U.K. for the next three years. The spot exchange rate is currently $1.50/ε. 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 per annum in the United States is 6% and in the U.K. is 4%. b. The expected future spot dollar-pound exchange rate in three years is $1.5826/£. c. The forward dollar-pound exchange rate for one-year maturity is $1.5455/£.

Step-by-step explanation:

a. To calculate the nominal interest rate per annum in the United States and the U.K., we can use the Fisher effect formula:

• Nominal Interest Rate = Real Interest Rate + Expected Inflation Rate.
• In the United States, the expected inflation rate is 3.5% and the real interest rate is 2.5%. So the nominal interest rate in the U.S. is 6%.
• In the U.K., the expected inflation rate is 1.5% and the real interest rate is 2.5%. So the nominal interest rate in the U.K. is 4%.

b. To calculate the expected future spot dollar-pound exchange rate in three years, we can use the formula:

• Expected Future Spot Rate = Spot Rate * (1 + Domestic Inflation Rate) / (1 + Foreign Inflation Rate).
• The spot exchange rate is $1.50/£. The U.S. inflation rate is 3.5% and the U.K. inflation rate is 1.5%.
• Plugging these values into the formula, we get:
• Expected Future Spot Rate = 1.50 * (1 + 0.035) / (1 + 0.015) = 1.5826.
• So the expected future spot dollar-pound exchange rate in three years is $1.5826/£.

c. To infer the forward dollar-pound exchange rate for one-year maturity, we can use the formula:

• Forward Rate = Spot Rate * (1 + Domestic Interest Rate) / (1 + Foreign Interest Rate).
• The spot exchange rate is $1.50/£. The U.S. nominal interest rate is 6% and the U.K. nominal interest rate is 4%. Plugging these values into the formula, we get:
• Forward Rate = 1.50 * (1 + 0.06) / (1 + 0.04) = 1.5455.
• So the forward dollar-pound exchange rate for one-year maturity is $1.5455/£.

Answer 2

The nominal interest rate per annum is 6.00% for the U.S. and 4.00% for the U.K., calculated using the Fisher effect. The expected future spot exchange rate in three years, considering inflation differences, is approximately $1.4351/£. We cannot infer the one-year forward rate without specific market data.

Step-by-step explanation:

To compute the nominal interest rates per annum for both the United States and the U.K., we use the Fisher effect, which states that the nominal interest rate is approximately the sum of the real interest rate and the expected inflation rate. Therefore, the nominal interest rate in the United States (US) would be 6.00% (2.5% + 3.5%) and in the U.K. it would be 4.00% (2.5% + 1.5%).

For the expected future spot dollar-pound exchange rate in three years, we need to consider the expected inflation rates in each country. Using the formula S = S0 * (1 + i_foreign)/(1 + i_domestic), where S is the future spot rate, S0 is the current spot rate, i_foreign is the inflation rate in the foreign (U.K.) country, and i_domestic is the inflation rate in the domestic (U.S.) country, we expect the future spot exchange rate (S) to be approximately $1.4351/£.

We cannot directly infer the forward exchange rate from the given information as it would require knowledge of the specific forward rate quotes or interest rate parity, which is not provided. The forward rate is influenced by the current spot rate and the interest rate differential between the two countries.