Question

Question 20 (0.8 points) According to the interest parity condition, if the domestic interest rate is 12 percent and the foreign interest rate is 10 percent, then the expected appreciation rate of the foreign currency against the domestic currency must be percent (put a negative sign if it is expected to depreciate). Question 21 (0.5 points) If the exchange rate at time t is €1/$. You invest $1 in an euro asset at t, which has an interest of 8%. If the exchange rate at time t+1 is €1.02/$, then your rate of return in terms of € is %. Question 22 (0.8 points) With a 10 percent interest rate on dollar deposits, a 7 percent interest rate on euro deposits, and an expected dollar appreciation of 7 percent over the coming year, the expected return on dollar deposits in terms of the dollar is %

Answer 1

20)

Domestic Interest rate = 12%

Foreign interest rate = 10%

IF S is the spot exchange rate and F forward exchange rate,

Than as per interest rate parity,

F = S *(1+.1)/(1+.12) = 0.98x

So forwward exchange rate is expected to fall by (1-0.98) =2%

21)

Initial Rate = 1Euro / $

Now investing 100 Euro will give 8% after time t+1

So Return in time t+1 = 100*1.08 = Euro 108

Now

Exchange rate after t+1 = 1.02Euro/$

So Return in $ terms = 108/ 1.02 = 105.88

5.88%

22)

Return on Dollar Deposits = 10%

Return on Euro Deposits = 7%

And Appreciation of Dollar =7%

Now if 1$/ Euro is the spot rate, forward rate = 0.9345 $ / Euro (1/1.07)

Return on 100 dollars = 100*1.1 = 110

And In Euros = 110 / .9345 = 117.7

So Total returns = 17.7%