Question

In: Economics

Congratulations! The Europe Department of the International Monetary Fund has just hired you. Your first assignment...

Congratulations! The Europe Department of the International Monetary Fund has just hired you. Your first assignment is to determine whether the uncovered interest parity approximation holds for the US dollar/Bulgarian lev (BL) exchange rate. (Please show your calculations). Today’s dollar/lev spot exchange rate = $0.50 Today’s interest rate on US dollar deposits = 0% Today’s interest rate on Bulgarian lev deposits = 1% Your department estimates that the expected dollar/lev exchange rate in one year is = 0.495 dollars to buy one lev. Does uncovered interest parity hold in this case? Why/Why not? (Show your calculations)

Solutions

Expert Solution

Spot $/lev exchange rate = $0.5 / lev

One year interest rate on dollars = 0%

One year interest rate on Bulgarian levs = 1%

Market expected spot rate in one year = $0.495 / lev

This is solved using uncovered interest rate parity formula:

market expected exchange rate = Spot rate * One year interest on dollars / One year interest on levs

= 0.5* (1+0%) / (1 + 1%)

= 0.5 * 1 / 1.01

Market expected exchange rate = $ 0.49505 / lev (By uncovered interest rate parity)

But Market expected spot rate in one year = $0.495 / lev

Uncovered interest parity hold in this case as the expected market spot rate by interest rate parity is eqaul to the market expected spot rate.


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