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5. On a particular day, the spot rate between Czech koruna (CKR) and the U.S. dollar is CKR30.35/$, while the interest rate on a one-year financial instrument in Czech is 7.5% and 3.5% in U.S. (8 credits)

a. What is your expected spot exchange rate a year later?

b. You’re concerned your investment in the Czech Republic because of the economic uncertainty in that country. When you expect the future value of the koruna, you require a risk premium of 2%. What is the expected future spot rate supposed to be?

Answers to Assignment Problems (5)

Part II

1. a. inflation differential (20% - 2.2%) = 17.8% U.S. should have appreciated by 17.8%

Implied exchange rate 1(1 + 17.8%) = Ps1.178/$ b. (1.178 – 3.2 ) / 3.2 = -63.19%

2. a. According to international Fisher equation: (1 + id) / (1 + if) = (1 + E[πd]) / (1 + E[πf])

id: interest rate in Denmark if: interest rate in Netherland πd: Danish inflation rate πf Dutch inflation rate

Since (1 + id) / (1 + if) = (1 +10%)/(1 + 7%) > 0

So, (1 + E[πd]) / (1 + E[πf]) >0, which means the expected inflation rate in Denmark would be greater than that in Netherland.

b. If Danish inflation is higher than Dutch inflation, Danish kroner will be expected to decrease in value against the Dutch guilder. (relative PPP theory)