The rate of inflation in Country A is 10% and in Country B is 30%. The real rate of interest in Country A is 2% and in B is 5%. The spot rate of exchange is 1.5 units of B’s currency for each unit of A’s currency.
(a) Estimate the yield on one-year Government bonds in both countries.
(b) Estimate the one-year forward rate of exchange.
(c) Estimate the spot rate of exchange at the end of one year.
(d) Can you reconcile the answers to (b) and (c)?
In each case, name the theories that you use to obtain your answers.