2 Questions - 1. ------------------ Brian Kenny, CFA, is an economist for Borderless Fund and was instructed by his colleague, John Dolan to create a forecasted exchange rate at the end of two years, Kenny’s investment horizon for the country of Kenya. The current spot exchange rate is 90.772 Kenyan Shillings (KS) for one euro (EUR). Kenny calculates annual inflation rates of 13% for the next two years for Kenya and 11% for the Economic European Community. Assuming relative purchasing power parity (PPP) holds, the expected spot exchange rate at the end of two years is: A) 92.4075 KS/EUR. B) 94.0725 KS/EUR. C) 89.1654 KS/EUR. Your answer: A was incorrect. The correct answer was B) 94.0725 KS/EUR. The KS is the foreign currency and the EUR is the domestic currency because the spot quote is KS/EUR: S1 = S0 × [(1 + iFC)2 / (1 + iDC )2] S1 = 90.772 × [(1 + 0.13)2 / (1 + 0.11)2] = 94.0725 KS/EUR The KS is expected to depreciate against the EUR over the next two years. ------------------------------------- 2. The domestic interest rate is 9% and the foreign interest rate is 7%. If the forward exchange rate is 5 domestic units per foreign unit, what spot exchange rate is consistent with interest rate parity? A) 4.91. B) 4.83. C) 5.09. Your answer: A was correct! F/S = (1 + rdomestic) / (1 + rforeign). Note: in this equation, exchange rates are quoted as Domestic/Foreign. S = F (1 + rF) / (1 + rD) = (5)(1.07) / (1.09) = 4.908 ------------------------------------------- My Question: What was the formula switched around? 2. says it’s (1+rDom) / (1+rForeign) while question one is 1. (1+Foreign)^2 / (1+Domestic)^2, etc… Can any one explain when is it the Domestic the numerator or denominator? Is it because of the Interest Rate Purity and Purchasing Power Parity equation?
easier to relate to this as always look at S and F as FC/DC use rfc on numerator, rdc on denominator. or Ifc on numerator/Idc on denominator S0=90.772 Kenyan Shillings (KS) for one euro (EUR) KS numerator Euro denominator iks=13%, ieuro=11% 90.722 * (1.13/1.11)^2 = 94.02 2nd problem. F=5 DC/FC S*(1+rdc/1+rfc) = F So S=F(1+rfc)/(1+rdc) They switched this around, gave you F instead…
I first see the how the exchange rate is given. In the first question: 90.772 Kenyan Shillings (KS) for one euro (EUR) So this will mean that on the other side Kenya inflation rate will be on top and Euro will be at bottom. F=(90.772 x 1.13^2)/1.11^2 In the second question: 5 domestic units per foreign unit So domestic unit will be on top on the other side and foreign and bottom. Since we are calculating the spot rate it will reverse: S=F x Foreign/Domestic
You can go through all the confusion described above, or just remember the standard: “base/counter” format. Counter is always in terms of “n”, while base is always “1”. I.E. since Kenyan shillings are 90.772 : 1.00 Euro, we know Euro is obviously the base currency. You always put the counter currency in the numerator, and the counter currency is always in terms of “n”, so if the number next to the exchange rate isn’t “1” (which would be the base, or “domestic”, if you prefer), its the counter currency and stick it in the numerator.
I got confused with the 2nd question too, till I noticed that the FORWARD exchange rate is the one given, and you need to find out the SPOT. By any of the methods given above: Forward rate = Spot rate x (1.09/1.07) But ofcourse, since we are finding out the spot rate - as idreesz reminds us 
: Spot rate = fwd rate x (1.07/1.09) = 4.908