Suppose that U.S. interest rates are 4 percent more than rates in the EU. a. Would...

Suppose that U.S. interest rates are 4 percent more than rates in the EU.

a. Would you expect the dollar to appreciate or depreciate against the euro, and by how much?

b. If, contrary to your expectations, the forward and spot rates are the same, which direction would you expect financial capital to flow? Why?

Expert Solution

Suppose that U.S. interest rates are 4 percent more than rates in the EU.

a. Would you expect the dollar to appreciate or depreciate against the euro, and by how much?

If US interest rates are 4% higher, investors from the EU will borrow at low rates from EU, and invest at high rates in the US.

Demand for US assets will rise, and supply of EU assets will rise.

This will cause the dollar to appreciate against the euro. The magnitude of appreciation will also be 4%. In time, the arbitrage opportunity will cease to exist.

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b. If, contrary to your expectations, the forward and spot rates are the same, which direction would you expect financial capital to flow? Why?

If the forward and spot rates are the same, and US interest rates are higher, it may imply that the EU assets are actually undervalued compared to the US. There may be no real gain in moving funds from the EU to the US. If EU assets are indeed undervalued, we may see flows from the US to the EU, to balance out this opportunity.

Rahul Sunny answered 2 years ago

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Suppose that U.S. interest rates are 4 percent more than rates in the EU. a. Would...

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