Question

In: Finance

4. Consider two countries: Japan and France. Suppose you saw the following information in the newspaper:...

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

  1. Does uncovered interest parity (in exact form) hold?
  2. If not, at what current spot rate would the uncovered interest parity hold (be satisfied)?
  3. How might the current spot rate be driven to this level you found in (b)? Explain. (Explain the adjustment mechanism that occurs through trade of currencies that makes arbitrage disappear).

Solutions

Expert Solution

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 :

  • Borrow Euro, and sell the Euros to buy Yen
  • Invest in Yen for one year
  • After one year, convert the Yen back into Euro at the spot rate after one year
  • Repay the Euro loan

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


Related Solutions

suppose two countries, France & Germany, use only capital and labor for production. France has 2050...
suppose two countries, France & Germany, use only capital and labor for production. France has 2050 units of capital and 916 units of labor and Germany has 816 units of capital and 270 units of labor. Both countries produce two goods, car and wine. In Germany there are 366 units of capital and 135 units of labor employed in the wine industry. In frnace, there are 926 units of capital and 618 units of labor employed in the wine industry....
Consider two countries, the United States (U.S.) and Japan. In the U.S., there are two firms,...
Consider two countries, the United States (U.S.) and Japan. In the U.S., there are two firms, Pikes Peak Steel (PPS) and General Motors (GM), both owned by U.S. citizens. In Japan, there is one firm, Toyota, owned by Japanese citizens. All of the employees of PPS and GM are U.S. citizens and all of the employees of Toyota are Japanese citizens. In a given year, PPS produces $6000 worth of steel and pays wages of $1500. It sells $2000 worth...
Consider two countries, France and Russia, and two goods, wine and vodka. Assume that in both...
Consider two countries, France and Russia, and two goods, wine and vodka. Assume that in both countries, both wine and vodka account for equal shares in their respective consumption baskets. Suppose that the dollar-price of wine in France is half of the dollar-price of wine in Russia. In order for absolute PPP to hold, what must be the ratio of the dollar-price of vodka in France relative to the dollar-price of vodka in Russia?
Suppose there are two countries, USA and Japan. USA is regarded as the home country and...
Suppose there are two countries, USA and Japan. USA is regarded as the home country and Japan is the foreign country. USA has 100 units of labor available and Japan has 80 units of labor. Both countries can produce only two goods, airplanes and cars. The output per hour of labor in the production of airplanes in the USA is 12, while in car production the output per hour of labor is 6. In Japan, the output per hour of...
Consider a Heckscher-Ohlin world with two countries (Japan and Ireland), two goods (Cameras and Linen), and...
Consider a Heckscher-Ohlin world with two countries (Japan and Ireland), two goods (Cameras and Linen), and two factors of production (labor(L) and capital(K)). Both factors of production are used in the production of each of these goods. Suppose the K/L ratio used to make linen is less than the K/L ratio used to make cameras. Also, the ratio of total capital to labor in the economy is higher in Japan than Ireland. Assume that Japan and Ireland have the same...
Suppose there are two countries: Japan and the United States, producing two goods, x- ray machines...
Suppose there are two countries: Japan and the United States, producing two goods, x- ray machines (x) and yucca plants (y). The following table shows the amount of labor inputs needed to make one unit of output of each of the two commodities in each of the two countries. Suppose Japan has 48 million workers and the United States has 24 million workers. x-ray yucca Japan 12 6 US 2 8 a.) (6 points) Graph the production possibility frontier (PPF)...
Consider following production possibilities for two countries Baguettes Cars Germany 1000 million 1 million France 2000...
Consider following production possibilities for two countries Baguettes Cars Germany 1000 million 1 million France 2000 million .8 million Which of the following is true? Group of answer choices France has an absolute advantage in the production of baguettes Germany has an absolute advantage in the production of both goods France has a comparative advantage in the production of cars France has an absolute advantage in the production of both goods
You need to send expatriate managers to two countries in Asia - Thailand and Japan. You...
You need to send expatriate managers to two countries in Asia - Thailand and Japan. You choose two candidates who work at the same level and get similar compensation package in the U.S. How would you design the expatriate compensation packages for the managers in each country so that they find it fair and acceptable offer? What kind of issues can come up when cosnidering this issue?
[4 pts] Consider two countries, Greece and Germany, that have joined a monetary union and suppose...
[4 pts] Consider two countries, Greece and Germany, that have joined a monetary union and suppose Greece is prone to sudden changes in the demand for their exports. What does this look like in the GG-LL graph and how does it affect their membership in the union?
Consider the following information on factor endowments for the two countries of Spain and Germany. Factor...
Consider the following information on factor endowments for the two countries of Spain and Germany. Factor Endowmetns USA China Labor Force 30 million 15 million Capital Stock 200,000 machines 400,000 machines 1)  If these two countries agrees to trade, what kind of restructuring would the countries face? 2) Would there be complete specialization in each country? 3) Would capital and labor remain fully employed in both the countries with persisting trade? Why or why not? 4) How would income distribution for...
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT