Question

Questions 1 and 2 will use the results of uncovered interest rate parity. 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^*)

1. 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

a)

The uncovered interest rate Parity is given as

Assuming E_e=2.5 and i*=0.03, the table calculates the foreign return for E=2.4,2.5, and 2.6

E	FR
2.4	0.0717
2.5	0.03
2.6	-0.0085

===================================================================

b)

Assuming E_e=2.5 and i*=0.05, the table calculates the foreign return for E=2.4,2.5, and 2.6

E	FR
2.4	0.0917
2.5	0.05
2.6	0.0115

==============================================================

c)

Assuming E_e=2.55 and i*=0.05, the table calculates the foreign return for E=2.4,2.5, and 2.6

E	FR
2.4	0.1125
2.5	0.07
2.6	0.0308

============================================================

d)

The results above is plotted in the figure below. The FR curve is falling straight lines giving negative relationship between spot rate and FR,

===============================================================

e)

From the above figure, the equilibrium spot rate is given as

• Case a-2.5
• Case b-2.55
• Case c-2.6