Question

Covered and uncovered interest rate parity, Purchasing Power Parity (25)

Explain the difference between the covered and the uncovered interest rate parity. What is the underlying idea behind these concepts? How does it relate to the Purchasing Power Parity and what are the differences? (10)

Suppose the one-year interest rate in the US is 5.5% and in Germany is 6.0%. The dollar per Euro exchange rate is 1.20. What is the current forward exchange rate on a 1-year contract? (5)

Suppose that the treasurer of IBM has an extra cash reserve of $100,000,000 to invest for six months. The six-month interest rate is 8 percent per annum in the United States and 7 percent per annum in Germany. Currently, the spot exchange rate is $1.20 per Euro and the six-month forward exchange rate is $1.18 per Euro. The treasurer of IBM does not wish to bear any exchange risk. Where should he/she invest to maximize the return? (10)

Answer 1

Answer 1

Uncovered Interest Rate Parity:the expected return on an uncovered (i.e., unhedged) foreign currency investment should equal the return on a comparable domestic currency investment

Foreign/domestic (f/d) notation, uncovered interest rate parity says the expected change in the spot exchange rate over the investment horizon should be reflected in the interest rate differential

%?Sef/d=if?id

Answer2

Purchasing Power Parity: examining the relationship between exchange rates and inflation differentials

a) Absolute version of PPP: nominal exchange rate will be determined by the ratio of the foreign and domestic broad price indexes

Sf/d = Pf/Pd

b) Relative version of PPP: The percentage change in the spot exchange rate (%?Sf/d) will be completely determined by the difference between the foreign and domestic inflation rates (?f – ?d)

%?Sf/d??f??d

c) Ex ante version of PPP:expected changes in the spot exchange rate are entirely driven by expected differences in national inflation rates

%?Sef/d=?ef??ed

%?Sef/d represents the expected percentage change in the spot exchange rate, while ?ed and ?ef represent the expected domestic and foreign inflation rates

Answer 3

Covered interest rate parity is based on an arbitrage relationship among risk-free interest rates and spot and forward exchange rates.

F(f/d)=S(f/d)× (1+iP[Actual360] /(1+iB[Actual360])

When currency will trade at a forward premium (FP/B > SP/B) if, and only if, the foreign risk-free interest rate(price currency) exceeds the domestic risk-free interest rate(Base currency) (iP > iB)

1.According to covered interest rate parity, arbitrage ensures that nominal interest rate spreads equal the percentage forward premium (or discount).

2.According to uncovered interest rate parity, the expected percentage change of the spot exchange rate should, on average, be reflected in the nominal interest rate spread

3.If ex ante PPP and the Fisher effect hold, then expected inflation differentials should equal both the expected change in the exchange rate and the nominal interest rate differential. This relationship implies that the expected change in the exchange rate equals the nominal interest rate differential, which is uncovered interest rate parity