An asset manager has conducted an extensive econometric study and proposes a forecasting model. He has found that a currency with a high interest rate tends to appreciate relative to a currency with
a low interest rate. The simple forecasting model for the one-year exchange rate is that a currency should appreciate over the year by the amount of the interest rate differential quoted today. For example, if the Australian dollar exchange rate is AUD/$ = 2 and the one-year interest rates in AUD and $ are 4% and 7%, respectively, the U.S dollar should move up by 3% relative to the Australian dollar, and your forecast for the exchange rate at the end of the year is AUD/$ = 2.06.
a. What is the current forward exchange rate?
b. What type of forward transaction would you conduct to capitalize on your forecast?
c. If everyone were using your model and following your strategy, what would happen to the exchange and interest rates?

Question

Quizplus · Accepted Answer

The Answer is a. According to the interest rate parity relation, F, the current forward exchange rate, is given by:

F = 2 \frac { 1.04 } { 1.07 } = 1.9439

AUD/$.
b. To capitalize on my forecast for the exchange rate at the end of the year (AUD/$ =2.06), I can buy forward dollar contracts for delivery in one year (AUD/$= 1.9439).
c. If every market participant was using my model, everyone would simultaneously conduct my type of forward transaction. Hence, the current forward exchange rate would instantaneously become equal to 2.06. The spot exchange rate and the interest rates would have to move to be consistent with this forward exchange rate value.

An Asset Manager Has Conducted an Extensive Econometric Study and Proposes