Assume that the current exchange rate between the Australian dollar and the U.K. pound is .5 (E = .5). If interest parity holds, and the Australian interest rate is 6% while the U.K. interest rate is 8%, the expected exchange rate in one year is ________. 0.52 0.49 0.51 0.40 0.48
Question
Assume that the current exchange rate between the Australian dollar and the U.K. pound is .5 (E = .5). If interest parity holds, and the Australian interest rate is 6% while the U.K. interest rate is 8%, the expected exchange rate in one year is ________. 0.52 0.49 0.51 0.40 0.48
Solution
The expected exchange rate in one year can be calculated using the formula for interest rate parity, which is:
E(expected) = E(current) * (1 + i(domestic)) / (1 + i(foreign))
Where: E(expected) is the expected exchange rate in one year, E(current) is the current exchange rate, i(domestic) is the domestic interest rate, and i(foreign) is the foreign interest rate.
In this case, the current exchange rate (E) is 0.5, the Australian interest rate (i(domestic)) is 6% or 0.06, and the U.K. interest rate (i(foreign)) is 8% or 0.08.
Substituting these values into the formula gives:
E(expected) = 0.5 * (1 + 0.06) / (1 + 0.08)
Solving this equation gives:
E(expected) = 0.5 * 1.06 / 1.08 = 0.49074074074
So, the expected exchange rate in one year is approximately 0.49. Therefore, the correct answer is 0.49.
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