Assume That Both the Law of One Price and the Expectations

question 1

Multiple Choice

Assume that both the law of one price and the expectations theory of forward rates hold. The spot rate for the Ruritanean doubloon is 0.455 doubloon/$, and the one-year forward rate is 0.476 doubloon/$. Suppose that next year's forecasted rate of inflation in Ruritania is now revised upward by 10%. How does this affect exchange rates?

• A) The current spot rate changes to 0.50 doubloon/$
• B) The forward rate changes to 0.524 doubloon/$
• C) Next year's expected spot rate changes to 0.501 doubloon/$
• D) The forward rate changes to 0.501 doubloon/$

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