Question: In November 2016, a Korean investor is considering investing in bank deposits in Korea and Japan. The annual interest rate on Korean deposits is 3.75 %, versus 1.25% on deposits in Japan. Suppose that the forward rate in November 2016 is equal to FWon/Yen = 8.1. In November 2016, the expected exchange rate EeWon/Yen is 8. The spot exchange rate in November 2016 is EWon/Yen = 7.9.
a. 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 and explain your answer.
b. Does uncovered interest parity hold in this example? If so, how do you know? Calculate the expected return on Japanese deposits (denominated in Korean won) in this case and explain your answer.
c. Suppose the spot exchange rate in November 2017 is equal to 8.2 won per yen. Calculate the Korean investor's actual return, assuming that he invests in Japanese deposits in November 2016. How do these answers compare with those from (b)? Explain.
d. Consider two Korean investors, one uses speculation and the other uses hedging. Based on your previous answers which one earned a higher return (or smaller loss) on Japanese assets between Nov. 2016 and Nov. 2017? Explain.