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I saw this MCQ in BPP P&R Mock 1. This is question 12.
Country X uses the dollar as it’s currency and country Y uses the Dinar.
Country X’s expected inflation rate is 5% per year, compared to 2% per year in country Y. Country Y’s nominal interest rate is 4% per year and the current spot rate between the 2 countries is 1.5000 dinar per $1.According to the four-way equivalence model, the following statements are correct as per the answer.
1. Country X’s nominal interest rate should be 7.06% per year.
2. The future (expected) spot rate after one year should be 1.4571 dinar per $1.Please can you explain the logic behind these answers?
In theory, interest rates and inflation rates are related in the same way.
So if Y’s interest rate is ‘I’, then (1+i)/1.04 = 1.05/1.02. Solving this gives i = 0.0706 (or 7.06%)Spot rates are best estimated using inflation rates and so the future spot rate in 1 years time = (1.02 / 1.05 ) x 1.5000 = 1.4571
Both of these ‘rules’ are explained in my free lectures. The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.
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