Question 3 (30 points) Suppose that the domestic interest rate is i the foreign
ID: 1121267 • Letter: Q
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Question 3 (30 points) Suppose that the domestic interest rate is i the foreign interest rate is i' the spot exchange rate is S and the forward rate is F 1. What are forward exchange rate markets and what is a forward contract? 2. What is the covered interest rate differential (CID)? 3. Suppose the CID is positive. Suppose capital is freely mobile. Explain how an in vestor can make unbounded profits 4. Suppose the CID is negative. Suppose capital is freely mobile. Explain how an investor can make unbounded profits 5. How can we use the CID to say something about capital controls? 6. Suppose f = In F = 02 and s-In S = 0, In class we used an approximation method to compute the forward discount fd. What is fd in this example? 7. Suppose that i = .02 and i. = 0. Use the approximation to compute the covered interest rate differential.Explanation / Answer
1. Forward exchange market is a market for contracts which ensures the future delivery of a foreign currency at a pre-decided specific exchange rate. The price of a forward contract is known as the forward rate.
A forward contract is a non-standardized contract between two parties. It is in order to buy or sell an asset at a specified future time at a pre decided price which agreed upon today. It is a derivative instrument.
2. Covered Interest Differential (CID) is defined as the difference between the interest rate differential and the forward premium (FP)
3. Interest rate is always higher in the domestic market. This is why the CID is always positive. Consequently, CIP arbitrage occurs only in one direction which is that the arbitrageurs borrow in the developed market and invest in the emerging market. This is how an investor makes profit.
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