Question

3) Suppose that the spot exchange rate S(¥/€) between the yen and the euro is currently
¥110/€, the 1-year euro interest rate is 6% p.a., and the 1-year yen interest rate is 3% p.a.
Which of the following statements is MOST likely to be true?
A. The high interest rate currency must sell at a forward premium when priced in the low
interest rate currency to prevent covered interest arbitrage
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B. Real interest parity does not hold
C. Uncovered interest parity requires equality of the return to investing in yen for 1-year
versus converting the yen principal into euros, investing the euros for 1-year, and then
selling the euro principal plus interest at the forward rate for yen
D. Covered interest parity between a 1-year yen-denominated asset and a eurodenominated asset of matching maturity holds if the forward exchange rate F(¥/€) <
S(¥/€)
E. The expected future spot rate, SE(¥/€), should be higher than the current spot rate to
ensure uncovered interest parity
4) Suppose that there are deviations from the covered interest parity. Arbitrage profits can be
earned by borrowing JPY, exchanging JPY to USD at the spot exchange rate, investing
the US dollars, and exchanging the USD investment to JPY at the forward rate to repay
the JPY debt in 1 year. Which of the following adjustments is MOST likely to restore the
covered interest parity?
A. An increase in US interest rate
B. A decrease in JPY interest rate
C. An increase in spot exchange rate, S(USD/JPY)
D. An increase in 1-year forward rate, F(USD/JPY)
E. An increase in expected future spot rate, SE(USD/JPY)
5) Suppose that the Japanese Yen (JPY) is pegged to the Australian dollar (AUD). You think
that there is a 25% probability that the JPY will appreciate relative to AUD by 1% over
the course of the next month, and there is a 75% probability that the JPY will remain
pegged to the Australian dollar. What interest differential per annum would prevent you
from speculating by borrowing JPY and lending AUD?
A. Australian interest rate minus Japanese interest rate is greater than 3% per year
B. Australian interest rate minus Japanese interest rate is less than 3% per year
C. Australian interest rate minus Japanese interest rate is greater than 3.6% per year
D. Australian interest rate minus Japanese interest rate is less than 3.6% per year
E. None of the above can prevent the speculation by borrowing JPY and leading AUD

Answer 1

3.  spot exchange rate S(¥/€) between the yen and the euro is currently ¥110/€

and Interest rate in Japan =3%,Interest rate in Eurozone =6%

From Interest rate parity

1 year forward rate = spot exchange rate* (1+ Interest rate in Japan)/(1+interest rate in Euro)

=110*1.03/1.06 = ¥106.8868/€

Statement A is false as high interest rate currency (Euro) will trade at a forward discount

Statement B is not correct as Real Interest parity may hold

Statement C is not correct as Forward rates are not available in Uncovered interest parity

Statement D is correct as from our calculations F(¥/€) < S(¥/€)

Statement E is not correct as the expected future spot rate is lower than the current spot rate.