Question

A.1)We know that the yen and the Swiss franc have a 100yen/ sf 1 exchange rate, meaning one swiss franc buys 100 yen in the forward ER market. If the swiss franc has an interest rate of -.06 and the yen rate is -.02, what is the spot exchange rate for IPT (interest parity theory) to be attained ? Show everything in yen terms and franc terms.
2) If there is no equilibrium initially, will there be equilibrium eventually? If so, what will transpire? Be extremely thorough. Your answer should include covered interest arbitrage.

Answer 1

1) Forward Rate = Spot rate *(1+Rd)/(1+Rf)

100 = Spot Rate*(1-0.06)/(1-0.02)

Spot rate = 104.26 yen / 1 Franc

If there is no equilibrium initially then also there will be equilibrium later on because people will increase the transaction in the particular currency and it will lead to equilibrium again let's understand with an example suppose we can earn a covered interest rate arbitrage by borrowing in Franc and investing into yen but as we increase our borrowing in Frac the demand for the franc will increase and demand of the borrowings is also increase in France it will leads to increase in borrowing rate in France while as we just keep investing in Japan, japan will have lots of funds so the lending will be cheaper in Japan so the interest rate in Japan will decrease and it will remove the covered interest rate arbitrage and leads to an equilibrium.

I hope my efforts will be fruitful to you ?....?