The interest rate on South Korean government securities with one-year
maturity is 4% and the expected inflation rate for the coming year is
2%.  The U.S. interest rate on government securities with one-year
maturity is 7% and the expected rate of inflation is 5%.  The current
spot exchange rate for Korea Won is $1 = W1,200.  Forecast the spot
exchange rate one year from today.  Explain the logic of your answer.

Hi bigred!
In ordert to answer this question, we must make use of the Interest
Rate Parity condition, which states that the expected return on
investment in dollar securities should equal the expected return on
investment in foreign currency-denominated securities (assuming
there's no risk of default on securities).

Basically, the idea of this condition is that if you invest 1 dollar
now in either US gov't securities or in Korea Gov't securities, the
expected amount of dollars you will receive in one year is the same.
So let's see how we can use this condition in order to derive the
expected exchange rate in one year.

If we invest $1 today in US securities, we'll have $1.07 in one year.

Let's see what happens if we invest the same $1 in Korean securities.
In order to buy Korean gov't securities, we must first convert the $1
into wons. So we get W1,200. We invest the W1,200 in Korean gov't
securities. Since the interest rate is 4%, we'll have
1200*(1.04)=W1,248.

Therefore, investing $1 today in Korean securities gives W1,248 in one
year. The interest rate parity, then, implies that this 1,248 wons
should be equal to the 1.07 dollars, so that the return is the same
irrespectively of where we make the investment. From that equality, we
get the exchange rate:

1.07 dollars = 1,248 wons
1 dollar = 1248/1.07 = 1,166.35 wons

So the expected exchange rate one year from now must be $1 =
W1,166.35. Otherwise, everyone would choose to invest in only one of
the two options.

Notice also that the inflation rate of US and Korea bear no relevance
for the argument.


I hope this helps! If you have any questions regarding my answer,
please don't hesitate to request a clarification. Otherwise I await
your rating and final comments.

Best wishes!
elmarto

This was my first time using this service.  Very fast and accurate on
answers.  Thanks for your time and making this experience enjoyable!