Suppose that the dollar-yen spot exchange rate is $0.05/¥ and the 90-day forward exchange rate is $0.06/¥. Assuming that covered interest parity holds, use the exact covered interest differential equation to determine whether Japanese interest rates are higher or lower than U.S. interest rates.
What will be an ideal response?
POSSIBLE RESPONSE: Let us assume, iJP = interest rate in Japan, iUS = interest rate in the U.S., e = spot exchange rate, and f = forward exchange rate.
Now, for the covered interest parity to hold, covered interest differential must equal to zero.
Therefore, CD = (1 + iJP) × f / e - (1 + iUS)
=> 0 = (1 + iJP) × 0.06 / 0.05 - (1 + iUS)
=> (1 + iJP) × 0.06 / 0.05 = (1 + iUS)
=> 0.06 / 0.05 = (1 + iUS) / (1 + iJP)
For this equation to hold, the numerator has to be greater than the denominator.
Thus, the U.S. interest rates must be higher than Japan's.
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