5. Assume that the covered and uncovered interest parities both hold at all time

Question

5. Assume that the covered and uncovered interest parities both hold at all times and that ef = x and ee= y represent today’s one-year forward and expected exchange rates of the dollar vis-à-vis the yen. If tomorrow everyone comes to expect the dollar to have a higher value relative to the yen than y, then ef will decline by the same amount that ee rises.

ef will rise by more than the increase in ee. ef will rise by less than the increase in ee. ef will rise by the same amount as ee. ef will remain unchanged.?

Explanation / Answer

Ans : ef will rise by less than increase in ee

Reason: Let us assume 1 USD = 100 Yen

Now, in order for dollar to appreciate than Yen, in case Yen increases to 150, the dollar increase should be less than 0.5, then only the return of dollar would be higher

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