Question

Uncovered interest rate parity states that the domestic return must equal the foreign return (FR), where FR = - i^* + (E^e – E)/E. This relationship can also be solved for the spot rate, which would yield E = E^e / (1 + i - i^*)

This question concerns the determination of the foreign return. Assume that the expected exchange rate is equal to 2.5 and that the foreign interest rate is equal to .03.

a. Calculate the expected foreign return for the following spot exchange rates (E)

i. 2.4

ii. 2.5

iii. 2.6

Be precise, taking your answer out to 3 decimal places.

b. Now assume that the foreign interest rate increases to .05. Calculate the foreign return for the same three spot rates: 2.4,2.5,2.6.

c. Now assume that the foreign interest rate is .05 but that the expected exchange rate is 2.55. Calculate the foreign return for the same three spot rates: 2.4,2.5,2.6.

d. Plot using graph paper or by computer the foreign return curves in parts a – c. The foreign return will be on the vertical axis and the spot rate on the horizontal axis. You should have three different foreign return curves.

e. Suppose the domestic interest rate is .03. Use your graph to find the equilibrium spot exchange rate in parts a – c.

Hint for problem 1: Follow the same approach as in the beginning of chapter 15, including table 15.1 and figure 15.2.

Answer 1

Answered:-

Uncovered Interest rate parity is given by the following relationship

E(S)/S = (1 + iA) / (1 + iB) [Multiplicative Model]

E(S)/S – 1 ? iA - iB

Where,

E(S) is the expected spot rate expressed as A/B

iA and iB are the returns of the two currencies A and B

a. For solving the problem, I have made use of the Excel. Kindly go through the screenshot. Also note that there are two variants of the model as presented above and I have computed the foreign returns using both for clarification. The one mentioned in the question is an additive model.

B.