Critical Thinking, (Spot Exchange Rate)

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 interest rate on U.S. government securities with one-year maturity is 7%, and the expected rate of inflation is 5%.The current spot exchange rate for Korean Won (W) is $1 = W1,200. Forecast the spot exchange rate one year from today (Hall, p. 318). The forecast spot exchange rate one year from now will be W1,166.35.
Explain the logic of this answer?
The logic for the above answer begins by understanding the meaning and relationship between Spot, Exchange Rate, Interest Rate Parity, and Fisher Effect.
1. Spot Exchange Rates
The interaction between supply and demand influences the exchange spot rate. The spot exchange rate is the daily rate which one currency is converted into another.
2. The Fisher Effect
In foreign currency transactions between two countries, the spot exchange rate changes in equal amounts as it moves the opposite direction to the difference in nominal interest rates between two countries. According to the Fisher effect, only the interest rate and not the inflation rate are used for calculating the spot interest rate.

3. Interest Rate Parity
The differences in currency values pertain to short-term interest rate differences between two countries. The real int. rate in the United States is 2% (7-% maturity – 5% expected inflation). The real interest for South Korean government securities is also 2% (4% maturity – 2% inflation). In both instances, the interest rate for the US and South Korea is equal at 2%. Taking into account our understanding of how the “Fisher Effect” functions we can safely say, the rate of currency exchange between the United States and South Korea will change in equal amounts as they move in opposing directions to the difference in nominal interest rates. Since the interest rate in the United States is 3% higher than it is in South Korea, the United States dollar should depreciate by 3%.
Investing $1.00 today at 7% will yield one year from today will be as follows: United States Securities: $1.00 = W1,200
Int. rate = 7%
S1.00 x 1.07 = $1.07 Korean Securities: $1.00 = W1,200 Int. rate = 4% W1,200 x $1.04 = W1,248 We must now apply the parity rate principle in order to arrive at the spot exchange rate. The Korean Won of 1,248 must equal the United States amount of $1.07. To achieve this, we must divide the 4% won value of 1,248 by the 7% U.S. value of 1.07%. The calculation is for the spot exchange rate is as follows: W1,248 / 1.07 = W1,166.35 The spot exchange ensures that the rate of exchange between two countries remains equal regardless of which country the currency is traded.