Question

2. Suppose that you are told that the interest rate on a US government bond is 3 percent compared to a 2 percent interest rate on a comparable German bond (i.e. equal risk and maturity).

a) Assuming that uncovered interest parity holds (so that investors are currently indifferent between the two assets), what would this imply about the market's expectation of the future value of the dollar in the exchange market? Explain. (10 points)

b) Suppose that the current spot rate is $1 = 1 euro. If uncovered interest parity holds, what is the implied expected exchange rate when the bond matures? (10 points)

c) Suppose that the current spot rate is $1 = 1 euro. If covered interest parity holds, what is the forward exchange rate today? (5 points)

Answer 1