Exchange Rate Relationships Problems

Exchange rate quote convention: USD/INR: 1 USD = xx INR, INR/USD: 1 INR = zz USD

1. The table below shows the spot and forward rates of USD/TRY.
USD/TRY Forward Rates (USD/TRY)

Country Currency Code Spot rate 3 months 6 months 12 months

Turkey Lira TRY 6.8523 7.0600 7.3799 8.0233

a) How many Turkish lira do you get for one US dollar? USD/TRY = 6.8523
b) What is the three-month forward rate for the lira? USD/TRY = 7.0600
c) Is the lira at a forward discount or premium on the US dollar? USD is at a forward premium
relative to TRY; TRY is at a forward discount relative to USD
d) Use the one-year forward rate to calculate annual percentage discount or premium on lira.
Premium = (1/8.0233)/(1/6.8523) – 1 = - 14.59%, or discount of 14.59% relative to USD
e) If the one-year interest rate on dollars is 2 percent, what is the one-year interest rate on lira?
From interest rate parity: 8.0233/6.8523 = (1+rlira)/1.02 => rlira = 19.43%
f) According to the expectations theory, what is the expected spot rate for lira in 3 months?
USD/TRY = 7.0600
g) According to purchasing power parity theory, what then is the expected difference in the
three-month rate of price inflation in United States and Turkey? 7.0600 / 6.8523 – 1 = 3.03%

Same Real Interest Rates

equals
4
Purchasing Power Parity

1 3
Interest Rate Parity

equals equals

2
equals
Expectations Theory
2. The table below provides the spot and forward rates for EUR/INR.
Forward (Months)
Spot 1 3 6
EUR/INR 85.76 87.12 87.80 88.88

a) Estimate the forward premium on Euro relative to INR i. For a 3-month contract.
Forward premium = 87.80-85.76 = 2.04 over 3 months
As % of spot rate: 2.04/85.76 x (12m/3m) = 9.51%
ii. For a 6-month contract.
(88.88-85.76)/85.76 x (12m/6m) = 7.28%
b) Estimate the forward discount on INR relative to Euro for a 3-month contract
INR/EUR Spot = 1/85.76 = 0.01166, INR/EUR 3m = 1/87.80 = 0.01139
Forward premium (3m contract) = (0.01139-0.01166)/0.01166 x (12m/3m) = - 9.29%
(discount)
State all the forward premium and discounts as annualised % of spot rates.

𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 = 𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒 − 𝑆𝑝𝑜𝑡 𝑟𝑎𝑡𝑒

𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒 − 𝑆𝑝𝑜𝑡 𝑟𝑎𝑡𝑒 𝑓
𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 𝑎𝑠 % 𝑜𝑓 𝑠𝑝𝑜𝑡 𝑟𝑎𝑡𝑒 = = −1
𝑆𝑝𝑜𝑡 𝑟𝑎𝑡𝑒 𝑠
To annualise, multiply by 12/m

3. Jim had USD 10,000 to invest. He could earn an interest rate of 6% on fixed deposits in
India, but only 2% in US. Jim wondered which alternative would give him higher return:
Alt A. Invest USD 10,000 in a six-month fixed deposit in US
Value after 6 months = 10,000 x (1+2%/2) = USD 10,100
Alt B. Convert USD 10,000 to INR at the spot rate and invest in a six-month fixed deposit in
India. Upon maturity of the deposit, convert the INR amount back to USD at a forward rate
contracted today with Jim’s bank.
Value after 6-months = (10,000 x 80) x (1+6%/2) = INR 824,000
If forward contract is booked, value on conversion to USD = 824,000 x 0.012257 = USD
10,100
Jim’s bank provided him the following quotes for INR/USD spot and six-month forward rates:
Spot: 1 INR = 0.0125 USD; 1 USD = 80 INR. Forward (6 month): 1 INR = 0.012257 USD
Compare the two alternatives. Explain the result using interest rate parity relationship.
There is no arbitrage opportunity since interest rate parity holds: Relative interest rates
(1.01/1.03) = forward/spot (0.012257/0.0125) = 0.981

4. The following table shows interest rates and exchange rates for the US dollar and Lilliputian
Nano (symbol x). The spot exchange rate is 1$ = 15x.
Complete the missing entries.
1 Month 3 Months 1 Year
Dollar Interest rate (% per year) 4 4.5 A
 Nano interest rate (% per year) 8.2 C 9.8
Forward USD/Nano D B 15.6
Forward discount on nano (% per year ) E 4.8 F

Using interest rate parity: 1 + rx / 1 + r$ = f$/x / s$/x

A.
By interest rate parity, [(1.098)/(1+ r$)] = 15.6/15
r$ 1-year = 1.098 x (15 / 15.6)] – 1 = .0558, or 5.58%

B.
3 month forward premium/discount on nano over $ (annualised) = - 4.8%
[fx/$/ sx/$– 1] x 4 = -4.8%
sx/$ =1/15
fx/$ = (1/15) x [1 – 0.012]
f$/x = 1/fx/$ = 15 / 0.988 = 15.1822

C.
𝑟$,3𝑚 for 3 months = 4.5%/4 = 0.01125
By interest rate parity, [(1+ rx)/(1+0.01125)] = (15.1822/15)
𝑟𝑥,3𝑚 for 3-months = [(15.1822 / 15) × (1.01125) – 1] = 2.353%
𝑟𝑥,3𝑚 = 2.353% x 4 = 9.41% per annum

D.
𝑟𝑥,1𝑚 for 1 month = 8.2%/12 = 0.006833; 𝑟$,1𝑚 for 1 month = 4%/12 = 0.003333
By interest rate parity, (1 + 0.006833) / (1 + 0.003333) = (fx/$/15)
fx/$ 1-month = [(1.006833) / (1.003333)] × 15 = 15.0523

E.
Forward premium = [f/s – 1] x 12 = [(15 / 15.0523) – 1] x 12 = –.0417,
=> Forward discount = 4.17% per annum

F.
fx/$ = 1/15.60, sx/$ = 1/15
forward premium = f/s – 1 = [(1/15.6)/(1/15)] – 1 = (15/15.6) - 1 = –.0385,
=> Forward discount = 3.85% per annum

[Note: The workings for C, D and E above are approximate, based on pro-rata interest rate
calculation. Actual estimates based on annually compounded interest rates will be different in
the case of C, D and E.* see calculations at the end of the document.]

5. In September 2021 the exchange rate for the Narnian leo was USD/LEO = 2,419. Inflation
in the year to September 2022 was about 30 percent in Narnia and 2 percent in the USA.
a) If purchasing power parity held, what should have been the nominal exchange rate in
September 2022?
Expected exchange rate 1$ = 2,419 / $1 × 1.30 / 1.02 = 3,083 leo
b) The actual exchange rate in September 2022 in the midst of a currency crisis was USD/LEO
= 8,325. What was the change in the real exchange rate?
Purchasing power parity (PPP) does not hold since the actual exchange rate is significantly
different from the exchange rate expected as per PPP.
Expected value of 1 leo = $ 1/3,083; actual value of 1 leo = $ 1/8,325
Change in real value of leo = (1/8,325 – 1/3,083)/(1/3,083)
= 3,083 / 8,325 – 1 = – 0.63, or decline of 63%

*Answers to 4 C, D & E on annually compounded interest rate basis

C.
𝑟$,3𝑚 for 3 months = (1+4.5%)1/4 – 1 = 0.011065
By interest rate parity, [(1+ rx)/(1+0.011065)] = (15.1822/15)
𝑟𝑥,3𝑚 for 3-months = [(15.1822 / 15) × (1.011065) – 1] = 2.335%
𝑟𝑥,3𝑚 = (1+2.335%)4 – 1 = 9.67% per annum
D.
𝑟𝑥,1𝑚 for 1 month = (1+8.2%)1/12 – 1 = 0.006589; 𝑟$,1𝑚 for 1 month = (1+4%)1/12 – 1 = 0.003274
By interest rate parity, (1 + 0.006589) / (1 + 0.003274) = (fx/$/15)
fx/$ 1-month = [(1.006589) / (1.003274)] × 15 = 15.04956
E.
Forward premium = [f/s – 1] x 12 = [(15 / 15.04956) – 1] x 12 = –.0395,
=> Forward discount = 3.95% per annum