In June 2013, a Korean investor was considering investing in bank deposits in Korea and Japan. The annual interest rate on Korean deposits is 6.25%, versus 3.75% on deposits in Japan. Suppose the forward rate in June 2013 was equal to Fwon/¥ = 8.2, the expected exchange (rate Korean won per Japanese yen (¥)) was equal to Eewon/¥ = 8.25 won/¥, and the spot exchange rate was equal to Ewon/¥ = 8.
Does covered interest parity hold in this example? If so, how do you know? Calculate the expected return in Japanese deposits (denominated in Korean won) in this case.
Does uncovered interest parity hold in this example? If so, how do you know? If not, what is the implied risk premium? Which deposit pays a higher expected return? Calculate the return on Japanese deposits (denominated in Korean won) in this case.
Suppose the exchange rate in June 2014 is equal to 8.528 won/¥. Calculate the Korean investor’s actual return, assuming that she invested in Japanese deposits in June 2013. How do these answers compare with those from part (b)?
Consider two Korean investors: one uses speculation and another uses hedging. Based on your previous answers, which one would earn a higher return (or a smaller loss) on Japanese assets between June 2013 and June 2014? Briefly explain why.