Question

The foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of return. The condition that the expected returns on deposits of any two currencies are equal when measured in the same currency is called the interest parity condition.
Consider the following two currencies, the dollar ($) and the euro (€). Let R$ and R€ represent the interest rates on dollar deposits and euro deposits respectively and let E$/€ represent the current exchange rate defined in terms of dollars per euro. Further, denote the expected exchange rate by Ee $/€
a. Write down the interest rate parity condition for this currency pair using the above notations.
b. Underline the term representing the return on dollar deposits in part (a). Graph and label this on a diagram with the vertical axis labelled “Exchange rate (E$/€)”and the
horizontal axis labelled “Rates of returns (in dollar terms)”.
c. Circle the term(s) representing the expected rate of return on euro deposits expressed in terms of dollars in part (a). Graph and label this on the same diagram in part (b).

Answer 1

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The foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of return. The condition that the expected returns on deposits of any two currencies are equal when measured in the same currency is called the interest parity condition.
Consider the following two currencies, the dollar ($) and the euro (€). Let R$ and R€ represent the interest rates on dollar deposits and euro deposits respectively and let E$/€ represent the current exchange rate defined in terms of dollars per euro. Further, denote the expected exchange rate by Ee $/€
a. Write down the interest rate parity condition for this currency pair using the above notations.
b. Underline the term representing the return on dollar deposits in part (a). Graph and label this on a diagram with the vertical axis labelled “Exchange rate (E$/€)”and the
horizontal axis labelled “Rates of returns (in dollar terms)”.
c. Circle the term(s) representing the expected rate of return on euro deposits expressed in terms of dollars...........!!!!!