Assignment 2: IFE Theory
Jack is considering an investment that involves buying Euros today and then converting them back to dollars one year from today. He is going to base his investment on the international Fisher effect and has asked for your help in evaluating the opportunity.
Currently, the one year interest rate is 6% in Europe. Interest rates in the U.S. for one year securities are at 4% and the current spot rate for Euros is €1.15. Jack’s strategy is to convert $110,000 USD into Euros today and one year from now convert them back to dollars. Will Jack’s strategy work?
- Using the IFE theory, what should the spot rate be one year from now for the Euro?
- Assume that the spot rate for the Euro in one year is €1.05. What would be the percentage return on the investment? If the spot rate is €1.18, what will be the percentage return?
- If Jack has a required minimum return of 15%, what must the spot rate be in one year?
- Would you recommend the strategy and the investment to Jack? Why or why not?
“E” represents the % change in the exchange rate
“i1” represents country A’s interest rate
“i2” represents country B’s interest rate
The rational for the IFE is that a country with a higher interest rate will also tend to have a higher inflation rate. This increased amount of inflation should cause the currency in the country with the high interest rate to depreciate against a country with lower interest rates.
The price quoted for immediate settlement on a commodity, a security or a currency. The spot rate, also called “spot price,” is based on the value of an asset at the moment of the quote. This value is in turn based on how much buyers are willing to pay and how much sellers are willing to accept, which depends on factors such as current market value and expected future market value. As a result, spot rates change frequently and sometimes dramatically.