7. Assume that today is January 1, U.S. $1.00 = .90 euros, and the interest rate

Question

7. Assume that today is January 1, U.S. $1.00 = .90 euros, and the interest rate on dollar deposits is 3%. If in one year: 1. the dollar appreciates relative to the euro by 10%, what will be the return on dollar deposits in terms of euros? 2. the dollar depreciates relative to the euro by 20%, what will be the return on dollar deposits in terms of euros? 3. the expected exchange rate is U.S. $1.00 = .95 euros, what is the expected rate of depreciation for the dollar? 4. the dollar is expected to appreciate 5%, what interest rate on euro deposits is required if the concepts of interest-rate parity and capital mobility are to hold?

Explanation / Answer

7. Assume that today is January 1, U.S. $1.00 = .90 euros, and the interest rate on dollar deposits is 3%. If in one year:

1. the dollar appreciates relative to the euro by 10%, what will be the return on dollar deposits in terms of euros?

In one year , U.S. $1.00 = 0.90/(1+10%)

U.S. $1.00 = 0.818182

Return on dollar deposits in terms of euros = 3 % + (0.90-0.818182)/0.818182

Return on dollar deposits in terms of euros = 13.00%

2. the dollar depreciates relative to the euro by 20%, what will be the return on dollar deposits in terms of euros?

In one year , U.S. $1.00 = 0.90/(1-20%)

U.S. $1.00 = 1.125

Return on dollar deposits in terms of euros = 3 % + (0.90-1.125)/1.125

Return on dollar deposits in terms of euros = -17%

3. the expected exchange rate is U.S. $1.00 = .95 euros, what is the expected rate of depreciation for the dollar?

Expected rate of depreciation for the dollar = (0.95-0.90)/0.95

Expected rate of depreciation for the dollar = 5.26%

4. the dollar is expected to appreciate 5%, what interest rate on euro deposits is required if the concepts of interest-rate parity and capital mobility are to hold?

In one year , U.S. $1.00 = 0.90/(1+5%)

U.S. $1.00 = 0.857143

Interest rate on euro deposits = (Spot rate/Expected rate * ( 1+ dollar interest rate)) - 1

Interest rate on euro deposits =(0.90/0.857143 * (1+3%)) – 1

Interest rate on euro deposits = 8.15%

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