1. Annualized interest rates in the U.S. and France on January 1, 1991 are 9% and 13%,respectively. The spot value of the franc is $0.1109.
(a) What is the expected exchange rate in one year under no arbitrage?
(b) Does approximate UIP predict an appreciation or depreciation of the U.S. dollar?Verify that answer a) is qualitatively correct.(c) What is the one-year forward rate under no arbitrage?
(d) Verify that UFR holds.
(e) Assume the inflation rate is 2% in the United States. What is the inflation rate inFrance under no arbitrage?
(f) Does approximate PPP predict an appreciation or depreciation of the U.S. dollar?Verify that answer f) is consistent with answer b) and answer e).
2. Assume annualized interest rates in the U.S. and the Euro Area are 1% and 3%, respec-tively. One euro is worth $1.20 and the one-year forward rate for the euro is $1.17669.
(a) What is the expected exchange rate in one year under no arbitrage?
(b) Is covered interest arbitrage profitable?
(c) You are a FX trader and forecast the euro to move to $1.22 in one year. Would youbuy or sell euros forward today? Why? Quantify your expected arbitrage profit.
(d) Your colleague disagrees with you. He expects the euro to move to $1.15 in oneyear. Should he buy or sell euros forward today? Why? Quantify his expectedarbitrage profit.One year later, the euro is worth $1.17.
(e) Both you and your colleague tradedagainstUIP, though in different directions.Did you make a profit or a loss on your trade? And your colleague? Why?