Question

Uncovered Interest Parity Explain the uncovered interest parity equation. (Write it and explain it). a. b. Why would we expect it to hold? l.e. what would happen if the equation does not hold? Assume the expected $/Yen exchange rate is 0.01 dollars per yen. Further assume that the US interest rate is 8% and the Japanese interest rate is 3%. According to uncovered interest parity, what would be the current S/Yen exchange rate? Show work. c.

Answer 1

a.

Uncovered Interest parity is when the difference in interest rate between two countries is equal to the expected change in their exchange rate of currencies.

The equation is as follows:

(1 + i_us) = [E(/Yen)/C(/Yen)]*(1 + i_yen)

where, i_us = interest rate in US

i_yen = interest rate in Japan

E(/Yen) = Expected exchange rate

C(/Yen) = current exchange rate

b.

If the equation does not hold, then the country would borrow at a lower interest rate and would use the loan to buy higher-yielding assets elsewhere.

c.

Putting the values in the above equation,

(1 + i_us) = [E(/Yen)/C(/Yen)]*(1 + i_yen)

=> (1 + 0.08) = [0.01/C(/Yen)]* (1 + 0.03)

=> 1.08/1.03 = [0.01/C(/Yen)]

=> C(/Yen) = 0.01* 1.05

=>C(/Yen) = 0.01048 $\simeq$ 0.01