Question

9) Suppose today that US nominal interest rate = 1% and German nominal interest rate = 6% and the current nominal exchange rate is E = €0.50/$. a. Use the uncovered interest party equation to compute the expected rate of appreciation of the US$ relative to the Euro. (Approximate form of the equation is fine.) b. Given your answer to a, what the expected future exchange rate? c. If you expect the US$ to depreciate relative to the Euro which bonds would you sell (i.e. borrow) and which would you buy (i.e. lend)? d. Suppose today, you buy Euros with dollars and purchase a German bond. One year from now the exchange is E = €1/$. What is your realized return in US dollars compared with the return you would have gotten if you had held US bonds? e) Is the ex post return in part d) consistent with uncovered interest parity? Why or why not?

Answer 1

9. an Ey According to interest rate parity the expected rate of depreciation is: Expected ovepreciation - it-it' =6% -1% . . : 5%. .. Expected appreciation : -5% by Then expected future exchange rate E (1 + 0-05) €0.525/$ more c) If we expect us & to depreciate than 5% Fli-Et so :: imit so Е Then the so investor should invest in us bond. But if the dollar appreciate less than 5 % it is profitable. d) for $1 current ewro exchange in €0.5 Ewro - German nominal interest 60% .. Expected retwen in lyr. - 0:5(1.06) =€0:53 The value of reture from igro investment $0.53 (as Ei=19) vol . 053-1 .. Realized retwens 998 X100 = -47%. . e) #ciate In this case donare appreciated by 50% Hence domestic bond must have been a profitable choice. The above example Shows that / prove the interest parity condition that in domestic currency too is profitable for investment if the currency expected to appre