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. Tbills 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's providing dollar worth of the pound is anticipated to boost, implies pound worth goes to understand and dollar worth goes depreciate

In this case interest rates on the T-bills can raise in United States of America and fall in United Kingdom of Great Britain and Northern Ireland

In this means, rate parity is maintained and equilibrium is achieved

Since United States of America T-bills rates ar planning to raise, one ought to go and purchase United States of America T-bills rather than United Kingdom of Great Britain and Northern Ireland T-bills

b) so as to attain equilibrium, the on top of logic holds smart all told the trade market.

In this case everyone can purchase United States of America T-bills rather than United Kingdom of Great Britain and Northern Ireland treasury bills and as a results of demand for United States of America T-bills United States of America dollar can once more appreciate and also the equilibrium is achieved.

In alternative words United Kingdom of Great Britain and Northern Ireland pound can depreciate once United States of America dollar is appreciating

In this case United Kingdom of Great Britain and Northern Ireland Govt. can interfere and sells its United States of America dollar reserves within the market, can decrease the demand for United States of America greenbacks and on top of mentioned logic falls and United Kingdom of Great Britain and Northern Ireland pound can stay higher

So so as to keep up their currency values, Government interfere within the foreign currency markets

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