Question

1) Today, a representative basket of goods is priced at $150 in the US and at £75 in the UK. The nominal interest rate paid on a USD denominated savings account is 2%, while the interest rate for a GBP denominated savings account is 3%. Assuming no arbitrage opportunity exists, and that real interest rates are the same in all countries,

1. a) What should the spot rate for the GBP/USD be if the absolute PPP holds?

2. b) Assuming that the absolute PPP holds, what should the 1 year forward rate for GBP/USD be?

3. c) Which currency would you expect to appreciate? By how much?

Answer 1

A) spot rate as per PPP = price in UK/price in US

= 75/150

= Pounds 0.5/$

B) 1 year rate = Spot rate(1+interest rate UK)/(1+interest rate US)

= 0.5(1+3%)/(1+2%)

= GBP 0.5049/$

C. DOLLAR is expected to appreciate by (0.5049-0.50)/0.50

= 0.98%