Question

A.1)We know that the yen and the Swiss franc have a 100 yen/ SF 1 exchange rate, meaning one swiss franc buys 100 yen in the forward ER market. If the Swiss franc has an interest rate of -.06 and the yen rate is -.02, what is the spot exchange rate for IPT (interest parity theory) to be attained? Show everything in yen terms and franc terms. 2) If there is no equilibrium initially, will there be equilibrium eventually? If so, what will transpire? Be extremely thorough. Your answer should include covered interest arbitrage.

Answer 1

Part (1)

If S is the spot rate then, S x (1 + yen interest rate) / (1 + swiss franc interest rate) = Forward rate

Hence, S x (1 - 0.02) / (1 - 0.06) = 100

Hence, spot rate, S = 100 x (1 - 0.06) / (1 - 0.02) = 95.92 = 95.92 yen / sf 1

Part (2)

There has to be equilibrium eventually otherwise there will be humungus arbitrage in the market.

If there is no equilibrium initially,

The exchange rate will be favorable for one country and unfavorable for the other.
Arbitrageurs in the market will stat trading the currencies for arbitrage gain.
Soon the weaker currency will be in high demand pushing up its prices. Thus the waeker currency will gain and the stronger currency will lose.
This will continue till the time equilibrium is achieved between the currecies and no further arbitrage is possible.
So, eventually in the long run, there will be equilibrium.