Consider a british investor with 500 pounds to place in a bank deposit either br

Question

Consider a british investor with 500 pounds to place in a bank deposit either britian or france. The one year interest rates are 3% in britian and 5% in france respectively. Take britian as the home country. The spot exchange rate is .90 pounds per euros

a) how much (in pounds) will this investor have if he puts his money in deposits for one year?

b) Write the covered interest party( CIP) equation. What is the one year rate if the CIP holds?

c) Write the uncovered interest party (UIP)equation. assuming the UIP holds, calculate the expected exchange rate

Explanation / Answer

a) If investor puts 500 pounds in a bank deposit in britiain, he will have (500+500x0.03) pounds;515 pounds.  

If investor puts 500 pounds in a bank deposit in France, he will have 583.3356 pounds approximaltely as,

.90 pounds=1 euro

or 1 pound =1/0.9 pounds

hence 500 pounds= 500/0.9 euros. France offers 5% interest, hence interest earned on 500/0.9 euros will be 27.78 euros.

Principal+ interest in euros= (500/0.9)+27.78=583.3356 euros.

Now, 1 euro=0.9 pounds, hence,

583.3356 euro=525.002 pounds

b) Covered interest party( CIP) equation-

1+i=(Ft/St)x(1+i*) where,

Ft is the forward exchange rate at time t ,

St s the spot exchange rate at time

i is the domestic interest rate and

i* is the interest rate in the other country

Ft=((1+i)/(1+i*))xSt =0.88

hence, the one year rate if the CIP holds is 0.88 pounds per euro.

c) Uncovered interest party (UIP)equation-

  1+i=(Et+k/St)x(1+i*) where Et is the expected exchange rate at time t+k. This can approximately be written as

i-i*=(Se-St)/St; Se being the expected future interest rate.

Putting values of i,i* and St in the equation above and solving this we get Se=0.882 pounds per euro.

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