DFG’s home currency is the D$.
DFG is heavily exposed to the exchange rate between the D$ and the L$, country L’s currency.
DFG’s treasurer has noted the following:
• Inflation has been running at 5% in DFG’s home country and 8% in country L
• Interest rates are 7% in DFG’s home country and 11% in country L
• The spot rate is D$1.0000 = L$2.1000 and the three month forward rate is D$1.0 = L$2.1196
Which of the following statements is consistent with these figures?
A . Interest rates are expected to continue unchanged, but country L’s inflation rate will increase in proportion to the inflation rate in DFG’s home country.
B . Interest rates are expected to continue unchanged, but country L’s inflation rate will decrease in proportion to the inflation rate in DFG’s home country.
C . Country L’s interest rate is expected to decline relative to that of DFG’s home country and inflation rates are expected to continue unchanged.
D . Country L’s interest rate is expected to increase relative to that of DFG’s home country and inflation rates are expected to continue unchanged.
Answer: A