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

The interest rate parity formula states that the forward rate should equal the spot rate multiplied by the ratio of the two countries' interest rates. In this case, we can assume that the spot rate for CYP/USD is 1 (since no information is provided). Using the interest rate parity formula, we can calculate the expected forward rate in five years:

1 × (1 + 0.15)^5 / (1 + 0.11)^5 ≈ 0.717

This means that Small expects the CYP to depreciate (i.e. less valuable compared to the USD) by about 28.3% over the next five years. Therefore, the answer is B, depreciate; 16.22% is not a valid option.

Small Corporation Would Like to Forecast the Value of the Cyprus