Question

Question 3 (a) State theuncovered interest rate parity condition. (b) Consider an open economy with a domestic interest rate of i, 3%, a nominal exchange rate between the domestic and foreign economy of E, =2, and where the foreign interest rate is i2%. In this case according to the "interest rate parity" what is the markets expectation of the future exchange rate E? (c) Consider an open economy with a domestic interest rate of i, 5 %, a nominal exchange rate between the domestic and foreign economy of E, = 1, and where the foreign interest rate is i 10%. Calculate the expected appreciation or depreciation of the domestic currency according to the theory of "uncovered interest rate parity." (d) Suppose i =4%, i* = 2% , and that the domestic currency is expected to depreciate by 3% during the coming year. Given this information, would you expect individuals to hold only domestic bonds or only foreign bonds? Explain Hint: using the simple or approximation form of the uncovered interest rate parity condition is easier.

Answer 1

3. a) According to uncovered interest nate parity states that the difference in interest rate between two countries 'n and equal to expected change in exchange rate of the countries. Mathametically ted chamo countries in inter earity TEOR Face (it in) b) Ex=2 Assuming inzino 3º - 17:2% OS ..EE 2x - 2002 atti c) Assuming :: 2 54%, EL=, T =100%. ED, 31x11.05-0.96 Appreciation : (1-0.96)*100 =4% d) If domestic currency expected to depreciate | :. E = (1 + vo) Fe + 1 3 E. According to Ulp! Fietis Et (462): 102 Et Then by actual expectation Etzl > E_ (**) or, (1+i) OC Eta (1+i*) EE That in retwen on domestic bond in expected to be less than retwen on foreign bond. The investor will hold only foreign bond.