PROBLEM SET Exchange Rates 1. Suppose, as in the lectures, that the interest rat

Question

PROBLEM SET Exchange Rates 1. Suppose, as in the lectures, that the interest rate on a dollar deposit is 2%, the euro deposit is 4% and exchange rate today is $1/€1. What do investors expect about the euro? 2. Assume that, due to the crisis, the ECB decides to decrease the interest rate. Which is the effect on today's value of the euro? Assume that investors do not change their expectation about the future. 3. Imagine that investors expect that the euro will depreciate in the future. Does it have an effect on today's exchange rate. 4. Read "Interest Rates, Carry Trades, and Exchange Rate Movements", FRBSF Economic Letter (17h November 2006). Discussion in class

Explanation / Answer

1.

If current USD/EUR exchange rate is 1 and Interest rate is 2% in USA and 4% in Europe this provides an arbitrage opportunity in which one can borrow from US deposits at 2% and invest in Euro deposits for 4% hence at the begining if 1 usd deposit would be equal to 1 EUR after a year Deposits in Euro will increase to 1.04 assuming the same exchange rate is same that is 1 hence converting eur deposits to USD deposits will lead 1.04 USD now by paying back deposits for whcih we borrowed USD at 2% need to pay back is 1.02 hence the net gain will be (1.04-1.02)=0.02

Hence this position of go short on USD and long on EUR yiels profiable avenue.

2.

If Country reduces the interest rate that will give a ngeative signal to investor who has deposits in Euro hence they woould try to find some other avenue where higher interest earning is possible that is investors would liquidate their EUR deposits hence supply for EUR will increse in respect to other base currecies which will depreciate exchange rate.

Rational Expectations say that we discount the future to present value as assuimg we have complete information the future prediction of exchange rate is converge to current exchange rate hence decrease in exchange rate should decrease if future exchange rate is expected to decrease as E(Xt)= X(t-1)/ I (t-1)

Xi is value of the X variable at period i & I (t-1) is set of information at time period (t-1)

Related Questions

Navigate

• Browse (All)
• Browse P
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.