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Suppose that in Japan the current interest rate is 5% per annum and one-year inflation rate is expected to be 3%. Meanwhile, the expected one-year
Suppose that in Japan the current interest rate is 5% per annum and one-year inflation rate is expected to be 3%. Meanwhile, the expected one-year inflation rate in France is 4%, and the US current interest rate is 3% per annum. The currency used in France is Euro. In the current period, assume absolute version PPP and as well as other international parity relationships hold. (a) What is the best estimate of the one-year forward premium (discount) at which the USD will be selling relative to the Euro (consider USD as the base currency)? What is the best estimate of the expected one-year inflation rate in US? Only in this sub-question, assume the approximate versions of various international parity relationship work reasonably well. (b) Suppose one year later, the realized spot exchange rate ($/) is 5% higher than the predictor in American term based on the unbiased hypothesis, but the realized inflation rates in France and US are consistent with the forecasts made one year earlier, as we learned from the question and your answer in (a), respectively. Please calculate the real exchange rate of Euro at this time point (i.e. one year after the current period), considering US dollar as the domestic currency. (c) Based your calculation in (b), what is the percentage over/under valuation of Euro against US dollar
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