19 Jun EXPLAIN THE INTUITION UNDERLYING YOUR RESULTS.
1. (10 points) Suppose that one year interest rates in the US are 0.01 (1%) and .03
(3%) in Europe. The current spot rate is $1.35/€, calculate the forward rate
consistent with covered interest rate parity. Explain your answer.
2. Suppose that one year interest rates in the US are 0% and that one year interest
rates in Europe are 4%. The current $/€ exchange rate is 1.2. Suppose that you
have $100 to invest.
a. (10 points) Use the uncovered interest rate parity (UIP) condition (the
approximation) and solve for the expected exchange rate, one year hence,
that is consistent with UIP. Show that with this particular exchange rate,
the returns in ‘like’ currencies are approximately the same.
b. (10 points) Explain the intuition underlying your results.
3. Suppose you have $1000 that serves as margin for a $9000 one year loan where
the interest rate is 1%. You invest the total = $10,000 in Europe where the
exchange rate is $1.25 $/€. The one year interest rate in Europe is 4%.
a. (10 points) According to UIP, what is the expected exchange rate one year
from now?
Consider the following two scenarios:
Scenario #1: The $/€ exchange rate remains constant over the holding period = 1
year
Scenario #2: The exchange rate after one year is 1.3 $/€
b. (10 points) Assuming scenario #1, what is your profit / loss and your rate
of return in $ when you close your position?
c. (10 points) Assuming scenario #2, what is your profit / loss and your rate
of return in $ when you close your position?
4. Suppose that you have the following information:
The inflation rate in the US is 2% and -2% in Japan (deflation in Japan)
The real exchange rate ($/yen) is appreciating by 2%.
a. (10 points) What is the implied change in the nominal exchange rate
($/yen)? Please show work. Explain the intuition of your result. 1 b. (10 points) Suppose that Bank of Japan (BOJ) successfully rids the
economy of deflation so that the new rate of inflation is 2%, same as the
US. Assuming all else constant, what is the implication on the nominal
exchange rate? Explain the intuition of your result. 2
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