explain why uncovered interest parity model is not useful in making exchange rate predictions? (200 words)

Expert Solution

Uncovered interest rate parity (UIP) model is not useful in making exchange rate predictions because of its theoretical limitations. While the theoretical and conceptual framework of UIP represents rational expectation models the model itself is based on the assumption that capital markets are efficient. In reality this is not the case and so UIP model is not useful in making exchange rate predictions.

It should also be noted that in the short-term as well as the medium-term the quantum of depreciation of the higher yielding currency is less than the implications of uncovered interest rate parity. In reality what might happen is that the higher-yielding currency has gained in strength instead of weakening.

Moreover UIP model does not cover exposure to foreign exchange risk. In case of UIP model there is no forward rate contracts, and hence only expected spot rate is used. UIP model also assumes foreign exchange equilibrium and this leads to an unrealistic implication that expected return of a domestic asset will equal the expected return of a foreign asset after adjusting for the change in foreign currency exchange spot rates. Higher interest rates leads to future depreciation and this is not sufficient for UIP to hold.

(200 words)

jeff jeffy answered 2 years ago

Questions 1 and 2 will use the results of uncovered interest rate parity. Uncovered interest rate parity...

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* + (Ee– E)/E. This relationship can also be solved for the spot rate, which would yield E = Ee/ (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...

covered and uncovered interest rate parity

What is the difference between covered and uncovered interest rate parity? What are the formulas?

Explain the theory of uncovered and uncovered interest rate parity. If you borrow Euros at 0.5%...

Explain the theory of uncovered and uncovered interest rate parity. If you borrow Euros at 0.5% interest, convert to dollars and deposit at 2.35% what future spot exchange rate would make uncovered interest rate parity hold?

Define uncovered interest parity. What is the relationship among the forward exchange rate, the spot exchange...

Define uncovered interest parity. What is the relationship among the forward exchange rate, the spot exchange rate, and the interest rate? Suppose the (1-year) interest rate on bank deposits is 2% in Canada and 1.75% in United States. If the (1-year) forward US$–C$ exchange rate is C$1.25 per US$ and the spot rate is C$1.2 per US$, will the C$ depreciation or appreciation against the US$ over one year, and by how much?

Questions 1 and 2 will use the results of uncovered interest rate parity. Uncovered interest rate...

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* + (Ee – E)/E. This relationship can also be solved for the spot rate, which would yield E = Ee / (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...

Covered and uncovered interest rate parity, Purchasing Power Parity (25) Explain the difference between the covered...

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)...

a) In the Dombusch model, the uncovered interest parity condition is assumed to hold continuously. If...

a) In the Dombusch model, the uncovered interest parity condition is assumed to hold continuously. If the domestic interest rate is lower than the foreign interest rate, then there is a need for an equivalent expected rate of appreciation of the domestic currency to compensate for the lower domestic interest rale. However, good prices adjust slowly over time to changes in the economy partly because wages are only adjusted periodically and partly because firms are also slow to adjust their...

The Central Bank of Japan increased the Japanese interest rate. Using uncovered interest parity, explain how...

The Central Bank of Japan increased the Japanese interest rate. Using uncovered interest parity, explain how this would affect the US economy. Using covered interest parity, explain how this would affect the U.S. economy.

Consider the uncovered interest-parity condition (UIP) using nominal interest rates. a. What happens to the exchange...

Consider the uncovered interest-parity condition (UIP) using nominal interest rates. a. What happens to the exchange rate if the foreign country lowers its nominal interest rates through expansionary monetary policy? How would that be reflected in the UIP curve graphically? Assume that the economy has a flexible exchange rate. b. What needs to happen if a country has a fixed exchange rate system and the foreign country lowers 1 its nominal interest rate through expansionary policy? (Note that a fixed...

Question 6. In your own words, explain interest rate parity. Do we observe interest rate parity...

Question 6. In your own words, explain interest rate parity. Do we observe interest rate parity in the real-world data (e.g. between Canada and the United States)? Why or why not?

Question