Suppose that one-year interest rates in the US are 0% and that one-year interest rates in Europe Answer
QUESTION 1:Suppose that one-year interest rates in the US are 0% and that one-year interest rates in Europe are 4%. The current $/€ exchange rate is 1.2. Suppose that you have $100 toINVEST.(10 points) Use the uncovered interest rate parity (UIP) condition (the approximation) and solve for the expected exchange rate, one year hence, that is consistent with UIP. Show that with this particular exchange rate, the returns in ‘like’ CURRENCIES are approximately the same.b. (10 points) Explain the intuition underlying your results.QUESTION 2:Suppose you have $1000 that serves as margin for a $9000 one year loan where the interest rate is 1%. You INVEST the total = $10,000 in Europe where the exchange rate is $1.25 $/€. The one-year interest rate in Europe is 4%.a. (10 points) According to UIP, what is the expected exchange rate one year from now?Consider the following two scenarios:Scenario #1: The $/€ exchange rate remains constant over the holding period = 1 yearScenario #2: The exchange rate after one year is 1.3 $/€b. (10 points) Assuming scenario #1, what is your profit / loss and your rate of return in $ when you close your position?c. (10 points) Assuming scenario #2, what is your profit / loss and your rate of return in $ when you close your position?QUESTION 3:Suppose that you have the following information:The inflation rate in the US is 2% and -2% in Japan (deflation in Japan) The real exchange rate ($/yen) is appreciating by 2%.d. (10 points) What is the implied change in the nominal exchange rate ($/yen)? Please show work. Explain the intuition of your result.e. (10 points) Suppose that Bank of Japan (BOJ) successfully rids the economy of deflation so that the new rate of inflation is 2%, same as the US. Assuming all else constant, what is the implication on the nominal exchange rate? Explain the intuition of your result.
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