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Question 3a
ZPS Co, whose home currency is the dollar, took out a fixed-interest peso bank loan several years ago when peso interest rates were relatively cheap compared to dollar interest rates. Economic difficulties have now increased peso interest rates while dollar interest rates have remained relatively stable. ZPS Co must pay interest of 5,000,000 pesos in six months’ time. The following information is available.
Interest rates which can be used by ZPS Co:
| Spot rate: | 12·500–12·582 pesos per $ |
| Six-month forward rate: | 12·805–12·889 pesos per $ |
| Borrow | Deposit | |
|---|---|---|
| Peso interest rates: | 10·0% per year | 7·5% per year |
| Dollar interest rates: | 4·5% per year | 3·5% per year |
Required:
(a) Explain briefly the relationships between:
(i) exchange rates and interest rates;
(ii) exchange rates and inflation rates.
Note: The total marks will be split equally between each part. (4 marks)