Small Corporation would like to forecast the value of the Cyprus pound (CYP) five years from now using forward rates. Unfortunately, Small is unable to obtain quotes for five-year forward contracts. However, Small observes that the five-year interest rate in the U.S. is 11%, while the Cyprus five-year interest rate is 15%. Based on this information, the Cyprus pound should ____ by ____% over the next five years.
A) appreciate; 16.22
B) depreciate; 16.22
C) appreciate; 6.66
D) depreciate; 6.66
E) none of the above

Question

Quizplus · Accepted Answer

According to Interest Rate Parity, the expected change in the exchange rate should reflect the difference in interest rates between two countries. In this case, Small Corporation observes that the Cyprus five-year interest rate is higher than the U.S. five-year interest rate, which indicates that the expected return on investment is greater in Cyprus than in the U.S. Therefore, investors will demand a higher return to invest in the U.S., which would cause the Cypriot pound to depreciate. The formula for calculating the expected change in the exchange rate is [(1 + Cyprus Interest Rate)/(1 + U.S. Interest Rate)] - 1, which results in [(1 + 0.15)/(1 + 0.11)] - 1 = 0.1622 or 16.22%. This indicates that the Cyprus pound is expected to depreciate by 16.22% over the next five years. Therefore, the correct answer is option B.

Small Corporation Would Like to Forecast the Value of the Cyprus