As of today,the spot exchange rate is €1.00 = $1.50 and the rates of inflation expected to prevail for the next year in the U.S.is 2 percent and 3 percent in the euro zone.What is the one-year forward rate that should prevail?

Question

Quizplus · Accepted Answer

To calculate the one-year forward rate using the Interest Rate Parity (IRP) formula, we need to account for the difference in the expected inflation rates between the U.S. and the euro zone. 
(1 + i$) = (1 + i€) × (1 + (E(€/$) - S(€/$))/S(€/$)) 
Where 
i$: U.S. interest rate = 2% 
i€: Euro interest rate = 3% 
S(€/$): Spot exchange rate = €1.00 = $1.50 
E(€/$): One-year forward rate

Plugging in the numbers, we get: 
(1 + 0.02) = (1 + 0.03) × (1 + (E(€/$) - 1.50)/1.50) 
1.02 = 1.03 × (1 + E(€/$) - 1.50)/1.50 
E(€/$) = 1.4854

Therefore, the one-year forward rate that should prevail is €1.00 = $1.4854, which is answer choice B.

As of Today,the Spot Exchange Rate Is €1