In: Finance
4. Consider two countries: Japan and France. Suppose you saw the following information in the newspaper: Interest rate on one-year Japanese deposits = 8%; Interest rate on one-year French deposits = 6%; Current spot rate: 100 yens per euro. Further suppose that based on your research on the two countries, you expect the spot rate is going to be 105 yens per euro a year from now. Round numbers to 3 decimal points. Pick home and foreign country and setup your equation appropriately
a]
As per uncovered interest parity, the difference in interest rates should equal the change in exchange rate over the period
Home country is France and foreign country is Japan
For uncovered interest parity to hold, future exchange rate = current exchange rate * (1 + foreign rate) / (1 + domestic rate)], where the exchange rate is quoted as number of foreign currency per unit of domestic currency
Future exchange rate = 100 * [(1 + 8%) / (1+ 6%)] = 101.887
However, the expected future exchange rate is 105.
Therefor uncovered interest parity does not hold
b]
let us say current spot rate is X. Then, uncovered interest parity would be satisfied if :
105 = X * [(1 + 8%) / (1 + 6%)]
X = 103.056
The current spot rate should be 103.056 Yen per Euro for uncovered interest parity to hold
c]
Since the uncovered interest parity does not hold currently, the arbitrage players in the currency markets would take these steps to make arbitrage profits :
This demand for Yen would increase the exchange rate until it reaches the equilibrium rate of 103.056. At this exchange rate, no arbitrage would be possible