Here are some statistics (in percentage points) (a) Suppose the current spot exc

Question

Here are some statistics (in percentage points)

(a) Suppose the current spot exchange rate is 100U/$, the expected spot exchange rate next year is 98U/$. An investor who has $1000 this year decides to invest in Japanese government bonds for one year. After one year, the investor will exchange all the proceeds in yens for dollars at the spot exchange rate next year. What is the expected rate of return of this investment?
(b) Does the investor in part(a) face exchange rate risk?
(c) Which investment generates a higher expected return? Investing in Japanese government bonds or investing in Treasury bills? Is the UIP satised?
(d) Suppose PPP does not hold, but UIP holds. Is Japan expected to undergo a real appreciation or depreciation relative to the dollar and by approximately what percent?

Explanation / Answer

1. Here the returns include the interest rate of 0.5% , inflation gain and appreciation of Yen.

The expected rate of return = (1000 *100 * 0.5% * 1.01 / 98) = $5.15 or 0.515%

2. The investor in Part (a) do face exchange rate risk as spot rate is determined at the exchange rate of the currency.

3. Investing in Japanese government bonds will genertes a higher return of 0.505% (alongwith the inflation) because of UIP effect. The "Uncovered Interest Parity" (UIP) condition says that the dollar return on a dollar investment should be the same as the dollar return on a Yen investment. Yes, the UIP is satisfied.

4. If PPP does not hold, but UIP holds, then as the Yen appreciates or Dollar depreciates, the real appreciation or depreciation relative to the dollar will be: +2%(spot rate) + 1%(inflation depreciates) = +3% (net effect)

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