Eco: Exchange Rates

I thought the currency with the higher exchange rate depreciated. So I converted the EUR/USD rate to USD/EUR rate which was 1.4256. Thus if EUR is depreciating against USD, then the answer should be higher than 1.4256?

Any help would be grand as I always get mixed up with these questions.

The EUR/USD spot exchange rate is 0.70145, and 1-year interest rate sare 3% in EUR and 2% in USD. The forward USD/EUR exchange rate is closest to:

A. 1.1426.

B. B. 1.4118.

c. 1.4396.

If you think of the currency in the denominator as a commodity – a barrel of oil, say – then you’ll get it right: if the price of oil changes from USD93.10/barrel to USD93.50/barrel, then oil appreciates (vis-à-vis the USD), and if it changes from USD93.10/barrel to USD92.70/barrel, then oil depreciates (vis-à-vis the USD).

So, if the USD/EUR spot rate is 1.4256, then, if the EUR appreciates (vis-à-vis the USD), the USD/EUR forward rate will be higher than 1.4256 (more USD for each EUR), and if the EUR depreciates (vis-à-vis the USD), then the USD/EUR forward rate will be lower than 1.4256 (fewer USD for each EUR).

First, change EUR/USD 0.70145 to USD/EUR 1.4256 (= 1 / 0.70145). Then remember that USD grows at the USD rate and EUR grows at the EUR rate (so, with USD in the numerator and EUR in the denominator, you’ll have the USD rate in the numerator and the EUR rate in the denominator):

USD/EUR(forward) = USD/EUR(spot) × (1.02/1.03)

= 1.4256 × 0.99029

= 1.411777

So . . . the answer’s B. The EUR is depreciating compared to the USD.

Thanks Magician. Makes sense. Sometimes a good nights sleep and a clear explanation does wonders. Thanks again.

Don’t stress people! It makes you dumber!

My pleasure. Glad it made sense.