Assume that interest rate parity holds. The U.S. five-year interest rate is 5% annualized, and the Mexican five-year interest rate is 8% annualized. Today's spot rate of the Mexican peso is $.20. What is the approximate five-year forecast of the peso's spot rate if the five-year forward rate is used as a forecast?
A) $.131.
B) $.226.
C) $.262.
D) $.140.
E) $.174.

Question

Quizplus · Accepted Answer

Interest rate parity implies that the forward exchange rate should offset the interest rate differential. The formula for the forward rate is: Forward Rate = Spot Rate * (1 + Domestic Interest Rate) / (1 + Foreign Interest Rate). Plugging in the values: Forward Rate = 0.20 * (1 + 0.05)^5 / (1 + 0.08)^5 = 0.174.

Assume That Interest Rate Parity Holds