Suppose that the current (simple annual) yields on 3-month U.S. (RA) and U.K. T-

Question

Suppose that the current (simple annual) yields on 3-month U.S. (RA) and U.K. T-bills (Rb) are 16 percent and 8 percent, respectively, and that the dollar value of the pound is expected to rise 1 percent during the next three months.

(a) How might the British and American T-bill and foreign exchange markets adjust to this situation? Present and discuss an equilibrium consistent with the concept of interest rate parity (IRP) and discuss the processes by which this equilibrium might be achieved. Should you buy U.S. or U.K. bills? At what U.S. T-bill yield would you be indifferent between U.K. and U.S. T- bills given the expected changes in the exchange rate?

(b) Governments frequently buy and sell foreign exchange for the purpose of smoothing fluctuations in exchange rates. Discuss the purposes for these interventions since 1971 and describe how these actions might interfere with the efficient allocation of resources by causing forward exchange rates to be biased predictors of spot rates.

Hints: IRP Condition: (1 + Ra) = (1 + Rb)(1 + Ee) = (1 + Rb)(1 + F/S) where Ra = 3-month U.S. T-bill yield,

• Rb = 3-month U.K. T-bill yield,
Ee = expected proportional change in the dollar value of the British pound, ƒ .

F = forward exchange rate ($/ƒ ), S = spot exchange rate ($/ƒ ).

Explanation / Answer

a) Since it is given that dollar value of the pound is expected to raise, implies pound value is going to appreciate and dollar value is going depreciate

In this case interest rates on the T-bills will raise in US and fall in UK

In this way, interest rate parity is maintained and equilibrium is achieved

Since US T-bills rates are going to raise, one should go and buy US T-bills instead of UK T-bills

b) In order to achieve equilibrium, the above logic holds good in all the free trade market.

In this case everybody will buy US T-bills instead of UK treasury bills and as a result of demand for US T-bills US dollar will again appreciate and the equilibrium is achieved.

In other words UK pound will depreciate when US dollar is appreciating

In this case UK Govt. will interfere and sells its US dollar reserves in the market, will decrease the demand for US dollars and above discussed logic falls and UK pound will remain higher

So in order to maintain their currency values, Government interfere in the foreign currency markets.

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