Question

The interest rate on South Korean government securities with one-year maturity is 4 percent, and the expected inflation rate for the coming year is 2 percent. The interest rate on U.S. government securities with one-year maturity is 7 percent, and the expected rate of inflation is 5 percent. The current spot exchange rate for Korean won is $1 = W1,200. Forecast the spot exchange rate one year from today. Explain the logic of your answer. Hill, Charles W. L.,Hill, Charles W. L.. Global Business Today (Kindle Locations 10475-10478). McGraw-Hill Higher Education. Kindle Edition.

Answer 1

Answer:

1 dollar =  1,166.35 wons

Explanation:

In order to answer this question, we must make use of the Interest

Rate Parity condition, which states that the expected return on

investment in dollar securities should equal the expected return on

investment in foreign currency-denominated securities.

Let's see what happens if we invest the same $1 in Korean securities.

In order to buy Korean government securities, we must first convert the $1

into wons. So we get W1,200. We invest the W1,200 in Korean government

securities. Since the interest rate is 4%, we'll have

1200*(1.04)=W1,248.

Therefore, investing $1 today in Korean securities gives W1,248 in one

year. The interest rate parity, then, implies that this 1,248 wons

should be equal to the 1.07 dollars, so that the return is the same

irrespective of where we make the investment.