Question

Assume the market is in zone 4 of the covered interest arbitrage parity (CIAP) grid where the interest rate differential is against the U.S. and the foreign currency is at a forward discount. (1) Determine the direction of the flow of funds. (2) What will happen to the interest rate differential and the forward discount as short-term funds move from one country to another? Explain why each change is happening

Answer 1

Answer to question no 1 :-

The transfer of short term money from one country to another leads to decrease in supply of money in home country leading to leftward shift of domestic supply curve .

Answer to question no 2 :-

Why is this shift happening :-

1) Hot money -Their is a chance for investors to get more interest on their funds

2) Capital flight - When there is a chance of fall in price of domestic currency and the spot rate will me more than forward rate then people tend to invest outside the country .

EFFECT ON INTEREST RATE DIFFERNTIAL :-

Due to decrease in supply of money from S1 to S2 , the demand remaining same , the value of currency rises , thus more amount of domestic currency will be needed to purchase dollars , thus the Exchange rate rises from E1 to E2

EFFECT ON FORWARD DISCOUNT :-

Forward discount is a situation in which future price of currency will be less than spot price . In the given figure the future price is less than spot price .Thus A to B represents forward discount.