The oneyear riskfree interest rate in Mexico is 10 percent T

The one-year risk-free interest rate in Mexico is 10 percent. The one-year risk-free rate in the United States is 2 percent. Assume that interest rate parity exists. The spot rate of the Mexican peso is $.14.

What is the forward rate premium?                                                           [4 MARKS]

What is the one-year forward rate of the peso?                                     [4 MARKS]

Based on the international Fisher effect, what is the expected change in the spot rate over the next year?                                                                             [4 MARKS]

If the spot rate changes as expected according to the IFE, what will be the spot rate in one year?                                                                                                [4 MARKS]

Compare your answers to (b) and (d) and explain the relationship.

[4 MARKS]

Solution

       1.02/1.1 -1=-0.7273

b. The forward rate is $.14 × (1 – .07273) = $.1298.

c.According to the IFE, the expected change in the peso is

       1.02/1.1 -1=-0.07273

                7.273%

d. $.14 × (1 – .07273) = $.1298

e.The answers are the same. When IRP holds, the forward rate premium and the expectedpercentage change in the spot rate are derived in the same manner. Thus, the forward premiumserves as the forecasted percentage change in the spot rate according to IFE.