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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?

Expert Solution

This is a concept where there should be no arbitrage opportunity.

So, if no arbitrage should exist, then the currency with lower interest rate should appreciate, while the currency with high interest rate should depreciate.

The relationship between spot rate and forward rate is given as

Fp/b = Sp/b *(1+ip)/(1+ib)

Here p is Price currency

b is base currency

ip is interest rate in price currency

ib is interest rate in base currency

Fp/b is forward rate

Sp/b is spot rate

In this question interest rate in euro is 0.5%

Interest rate in USD is 2.35%

So, USD will depreciate, in future.

Spot USD/EUR = 0.91

Todays rate is 0.91 EUR is 1 USD

In future

Forward USD/EUR = Spot USD/EUR*(1+2.35%)/(1+0.5%)

Forward USD/EUR = Spot USD/EUR * 1.0184

= 0.9267

Rahul Sunny answered 2 years ago

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