Assume that both the law of one price and the expectations theory of forward rates hold. The spot rate for the Ruritanean doubloon is 0.455 doubloon/$, and the one-year forward rate is 0.476 doubloon/$. Suppose that next year's forecasted rate of inflation in Ruritania is now revised upward by 10 percent. How does this affect exchange rates?
A)The current spot rate changes to 0.500 doubloon/$.
B)The forward rate changes to 0.524 doubloon/$.
C)Next year's expected spot rate changes to 0.501 doubloon/$.
D)The forward rate changes to 0.501 doubloon/$.

Question

Quizplus · Accepted Answer

According to the expectations theory of forward rates, the forward rate is an unbiased predictor of the future spot rate, and therefore, the expected one-year spot rate next year would be 0.476 doubloon/$ + 10% = 0.5236 doubloon/$. However, the law of one price states that the exchange rate should adjust to reflect the relative inflation rates between the two countries. Thus, if Ruritania's inflation rate is expected to increase by 10%, the doubloon should depreciate by the same amount to maintain the law of one price. Therefore, the new expected one-year forward rate would be 0.476 doubloon/$ + 10% = 0.5236 doubloon/$. Since the current one-year forward rate is 0.476 doubloon/$, it would need to be adjusted upward to reflect this new expectation, resulting in a new forward rate of 0.476 doubloon/$ * (1+10%) = 0.5236 doubloon/$ or choice B.

Assume That Both the Law of One Price and the Expectations