How to use the Fisher Effect to determine exchange rates
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Due to the integrated nature of their capital markets investors in both the United States and the U.K. require the same real interest rate 2.5 percent on their lending. There is a consensus in capital markets that the annual inflation rate is likely to be 3.5 percent in the U.S. and 1.5 percent in the U.K. for the next three years. The spot exchange rate is currently $1.50/pound.
A. Compute the nominal interest rate per annum in both the U.S. and U.K. assuming that the Fisher Effect holds.
B. What is your expected future spot dollar pound exchange rate in three years from now?
C. Can you infer the forward dollar pound exchange rate for one year maturity?
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Solution Summary
Two calculations are shown in full to determine nominal interest and forward dollar pound exchange rate.
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A. Compute the nominal interest rate per annum in both the U.S. and U.K. assuming that the Fisher Effect holds.
a. Nominal rate in US = ...
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