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Thursday, March 28, 2013

How to forecast long term exchange rates

Imagine you are interested in estimating the exchange rate between the Chilean Peso and the USD in say...   20 years. Using Interest RateParity, we can easily tackle this question. Imagine the current spot rate is 500CLP=1USD.  Assume you are given the following rates and yield curve.

Recall that Interest Rate Parity states that   

This means that the future exchange rate is a function of the interest rate differentials between the two countries. It is VERY important to be aware of what is home and what is abroad…
Our spot rate is given in CLPs per USD. This implies that home is Chile.   With this in mind, we can calculate that the exchange rate 20 years from now should be  813.29 CLPs per 1 USD.

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