Consider two bonds, one issued in euros in Germany, and one issued in dollars ($) in the United States. Assume that both government securities are one-year bonds-paying the face value of the bond one year from now. The exchange rate, E, stands at 1 dollar = 0.75 euro
a. The face values and prices on the two bonds are given by
b. Compute the expected exchange rate next year consistent with uncovered interest parity.
c. If you expect the dollar to depreciate relative to the euro, which bond should you buy?
d. Assume that you are a U.S. investor. You exchange dollars for euros and purchase the German bond. One year from now, it turns out that the exchange rate, E, is actually 0.72 11 dollar = 0.72 euro2. What is your realized rate of return in dollars compared to the realized rate of return you would have made had you held the U.S. bond?
e. Are the differences in rates of return in (d) consistent with the uncovered interest parity condition? Why or why not?