Answers to End of Chapter 7 Questions

36. IRP and Changes in the Forward Rate. Assume that interest rate parity exists. As of this
morning, the 1-month interest rate in Canada was lower than the 1-month interest rate in the U.S.. Assume that as a result of the Fed’s monetary policy this afternoon, the one-month interest rate in the U.S. declined this afternoon, but was still higher than the Canadian one-month interest rate. The one-month interest rate in Canada remained unchanged. Based on the information, the forward rate of the Canadian dollar exhibited a ________ [discount or premium] this morning that _________[increased or decreased] this afternoon. Explain.

ANSWER: The premium decreased. For all situations in which the foreign interest is less than the US, the forward rate should exhibit a premium that is the same as the difference in interest rates. The interest rate differential based on IRP would result in a forward rate premium. The interest rate differential is reduced in the afternoon, but still in the same direction so a premium still exists.

37. Deriving the Forward Rate Premium. Assume that the spot rate of the Brazilian real is $.30
today. Assume that interest rate parity exists. Obtain the interest rate data you need from Bloomberg.com to derive the one-year forward rate premium (or discount), and then determine the one-year forward rate of the Brazilian real.

ANSWER: Obtain the one-year U.S. interest rate and one-year Brazilian interest rate. Plug the interest rate into the forward rate premium formula:

Forward rate (FR) Premium = [(1 + U.S. interest rate)/(1 + Brazilian interest rate)]-1

Derive the FR as $.30 x (1 + FR Premium).

38. Change in the Forward Premium Over Time. Assume that interest rate parity exists and
will continue to exist. As of today, the one-year interest rate of Singapore is 4% versus 7% in the U.S. The Singapore central bank is expected to decrease interest rates in the future so that as of December 1, you expect that the one-year interest rate in Singapore will be 2%. The U.S. interest rate is not expected to change over time. Based on the information, explain how the forward premium (or discount) is expected to change by December 1.

ANSWER: The forward premium will become larger. For all situations in which the foreign interest is less than the US, the forward rate should exhibit a premium that is the same as the difference in interest rates. The differential is expected to increase over time, so the premium will become larger.