25 Comparing market-based forecasts. For all parts of this question, assume that interest rate parity exists, the prevailing one-year UK nominal interest rate is low, and that you expect UK inflation to be low this year.

a Assume that the country Dinland engages in much trade with the United Kingdom and the trade involves many different products. Dinland has had a zero trade balance with the United Kingdom (the value of exports and imports is about the same) in the past. Assume that you expect a high level of inflation (about 40%) in Dinland over the next year because of a large increase in the prices of many products that Dinland produces. Dinland presently has a oneyear risk-free interest rate of more than 40%. Do you think that the prevailing spot rate or the oneyear forward rate would result in a more accurate forecast of Dinland’s currency (the din) one year from now? Explain.

b Assume that the country Freeland engages in much trade with the United Kingdom and the trade involves many different products. Freeland has had a zero trade balance with the United Kingdom (the value of exports and imports is about the same) in the past. You expect high inflation (about 40%) in Freeland over the next year because of a large increase in the cost of land (and therefore housing) in Freeland. You believe that the prices of products that Freeland produces will not be affected. Freeland presently has a one-year risk-free interest rate of more than 40%. Do you think that the prevailing one-year forward rate of Freeland’s currency (the fre)

would overestimate, underestimate, or be a reasonably accurate forecast of the spot rate one year from now? (Presume a direct quotation of the exchange rate, so that if the forward rate underestimates, it means that its value is less than the realized spot rate in one year. If the forward rate overestimates, it means that its value is more than the realized spot rate in one year.