13) For the following 15 cases, compare the dollar rates of return on dollar and euro deposits.
14) For the table below calculate the EXACT relationship.
15) Assume that the euro interest rate is constant at 5 percent, and that the expected exchange
rate is 1.05 dollars per one euro. Find the expected dollar return on euro deposits for the
following cases.
16) Using the data in the table above, plot today’s dollar/euro exchange rate against the expected
dollar return on euro deposits.
17) Determine for each, whether the interest parity condition holds or not, if = 1.10
Answer:
14.4 Equilibrium in the Foreign Exchange Market
1) Which one of the following statements is the MOST accurate?
A) Since dollar and yen interest rates are measured in comparable terms, they can move quite
differently over time.
B) Since dollar and yen interest rates are not measured in comparable terms, they can move quite
differently over time.
C) Since dollar and yen interest rates are measured in comparable terms, they move quite the
same over time.
D) Since dollar and yen interest rates are measured in comparable terms, they still move quite
differently over time.
E) Since dollar and yen interest rates are so similar, they move quite the same way over time.
2) Suppose that the one-year forward price of euros in terms of dollars is equal to $1.113 per
euro. Further, assume that the spot exchange rate is $1.05 per euro, and the interest rate on dollar
deposits is 10 percent and on euro it is 4 percent. Under these assumptions
A) interest parity does not hold.
B) interest parity does hold.
C) it is hard to tell whether interest parity does or does not hold.
D) Not enough information is given to answer the question.
E) interest parity fluctuates.
3) What is the interest parity condition?
4) Explain why the interest parity condition must hold if the foreign exchange market is in
equilibrium.
5) Calculate the interest rate in the United States, if interest parity condition holds, for the
following 15 cases.
6) Calculate the interest rate in the euro zone if interest parity condition holds, for the following
15 cases.
7) Assume the U.S. interest rate is 10 percent, and the interest rate on euro deposits is 5 percent.
For the following exchange rates, find the forward exchange rates.
8) Calculate the Expected Dollar Depreciation Rate against the euro and the expected dollar
return on euro deposits if the expected exchange rate is $1.10 per euro.
Answer:
14.5 Interest Rates, Expectations, and Equilibrium
1) Which one of the following statements is the MOST accurate?
A) A rise in the interest rate offered by dollar deposits causes the dollar to appreciate.
B) A rise in the interest rate offered by dollar deposits causes the dollar to depreciate.
C) A rise in the interest rate offered by dollar deposits does not affect the U.S. dollar.
D) For a given euro interest rate and constant expected exchange rate, a rise in the interest rate
offered by dollar deposits causes the dollar to appreciate.
E) A rise in the interest rate offered by the dollar causes the euro to appreciate.
2) Which one of the following statements is the MOST accurate?
A) For a fixed interest rate, a rise in the expected future exchange rate causes a rise in the current
exchange rate.
B) For a fixed interest rate, a rise in the expected future exchange rate causes a fall in the current
exchange rate.
C) For a fixed interest rate, a rise in the expected future exchange rate does not cause a change in
the current exchange rate.
D) For a given dollar interest rate and a constant expected exchange rate, a rise in the interest
rate of the euro causes the dollar to depreciate.
E) For a fixed interest rate, a fall in the expected future exchange rate causes a rise in the current
exchange rate.
3) Discuss the effects of a rise in the dollar interest rate on the exchange rate.
4) Discuss the effects of a rise in the interest rate paid by euro deposits on the exchange rate.
5) Explain why (holding interest rates constant), a rise in the expected depreciation in a country’s
currency leads to depreciation of that currency today.
6) Show graphically a drop in the interest rate paid by euro deposits. What is the effect on the
dollar?
7) Show graphically a drop in the interest rate offered by dollar deposits, R$, and the effect on
the exchange rate, .
14.6 Appendix to Chapter 14: Forward Exchange Rates and Covered Interest Parity
1) The covered interest rate parity condition can be stated as follows: The interest rate on dollar
deposits equals the interest rate on euro deposits ________ the forward ________ on euros
against dollars.
A) plus; premium
B) minus; premium
C) plus; discount
D) minus; discount
E) times; premium
2) The covered interest rate parity condition can be stated as follows: The interest rate on dollar
deposits equals the interest rate on euro deposits ________ the forward ________ on dollars
against euros.
A) plus; discount
B) minus; premium
C) plus; premium
D) minus; discount
E) times; premium