Lecture 4

Question 1

Briefly discuss the concept of interest rate parity

Answer 1

Covered Interest Rate Parity (CIRP): States that the difference between domestic and foreign interest rates is offset by the forward premium or discount in the exchange rate. This applies when a forward contract hedges exchange rate risk.

Uncovered Interest Rate Parity (UIRP): Suggests that the interest rate differential between two countries equals the expected percentage change in their exchange rates. It does not involve hedging and assumes investors accept exchange rate risk.

In essence it keeps the market balanced to align interest rates and exchange rates. If one country has higher interest rates, its currency will either weaken in the future (to cancel out the gain) or the forward exchange rate will adjust.

Question 2

what is formula for 3 month forward?

Answer 2

ForwardPremium/Discount(%)=(ForwardRate - Spot Rate / Spot Rate)×3/12 ×100

If negative = discount
If positive = premium
Both in percentages

Question 3

Critically evaluate the importance of the purchasing power parity.

Answer 3

PPP provides a theoretical framework for understanding long-term exchange rate movements. It suggests that currencies of countries with higher inflation will depreciate relative to those with lower inflation. PPP is often used to determine whether a currency is overvalued or undervalued. Tools like the Big Mac Index simplify this concept for real-world application. It helps economists and policymakers compare living standards and economic productivity across countries by adjusting for differences in price levels.

Question 4

Formulas for covered and uncovered

Answer 4

Covered: 1+R = (F/S) (1+R)
Uncovered: r-r = s^e+1 -s