8-1 Money and foreign exchange markets in London and New York are very efficient. The following information is available:

Assumptions London New York Spot exchange rate ($/) $1.3860 $1.3860

One-year Treasury bill rate 3.800% 4.200%

Expected inflation rate ? 2.000%

What do the financial markets suggest for inflation in the UK next year? (Hint: use the equation for the exact Fisher Effect.)

b. Estimate today's one-year forward exchange rate between the dollar and the pound, knowing the current spot rate and the current interest rate quotes for the US and the UK.

SOLUTION: Assumptions London New York Spot exchange rate ($/) $1.3770 $1.3770

One-year Treasury bill rate 3.750% 4.100%

Expected inflation rate ? 1.800%

a. What do the financial markets suggest for inflation in the UK next year?

According to the Fisher effect, real interest rates should be the same in both the UK and the U.S.

Since the nominal rate = [ (1+real) x (1+expected inflation) ] - 1:

1 + real rate = (1 + nominal) / (1 + expected inflation)

1 + nominal rate 103.750% 104.100%

1 + expected inflation ? 101.800%

So 1 + real = % %

and therefore the real rate in the US is: %

The expected rate of inflation in the UK is then: %

b. Estimate today's one-year forward exchange rate between the dollar and the pound, assuming IRP

. Spot exchange rate ($/) 1.3770

US dollar one-year Treasury bill rate 4.100%

UK pound one-year Treasury bill rate 3.750%

One year forward rate ($/)