Question

Suppose the spot and three-month forward rates for the yen are ¥102.20 and ¥101.19, respectively.

Answer 1

a. A future yen is expected to buy more dollars. It is expected to get stronger.

b. There is insufficient information to determine the difference in inflation rates. We can determine that the expected rate of inflation over the next 3 months in the US is about 102.20/101.19 times that in Japan, higher by a factor of 1.00998. Annualized, this is 1.00998⁴ ≈ 1.04053. That is, the annual rate of inflation in the US is expected to be about 1.0405 times that in Japan, or about 4.05% higher than in Japan. (This will be the approximate difference if the rate of inflation in Japan is given the value 1.)