Question: Answer the following questions concerning covered and uncovered interest rate differentials and parity conditions:
a. Suppose the spot dollar-euro exchange rate is $1.20/€ , and the 60-day forward rate is $1.24/€. Is the euro selling at a forward discount or premium? What about the dollar?
b. Now suppose the interest rates on one-year U.S. and Eurozone (EMU) bonds are rUS = 5% and rEMU = 3%. You expect that, one year from now, the dollar-euro exchange rate will be at $1.26/€. Today the rate is $1.20/€. Which should you invest in, the U.S. or EMU bond? Explain Hint use uncovered interest rate parity to get your answer.
c. Finally, suppose that the interest rate in the United Kingdom is rUK = 2% (the U.S. interest rate is still rUS = 5%). Assume the U.S. is the home currency. If the (uncovered) "interest rate parity" condition holds between the U.S. and U.K., what must be the market's expectation of how much the U.S. dollar will appreciate or depreciate relative to the U.K. pound over the next year?