Problem set The interest rate parity condition. 1. Calculate the US interest rate (of the US bond) assuming that the uncovered interest parity (UIP) holds. a. A Polish bond pays i=5% and in the same time the zloty is expected to depreciate with respect to the USD by 4% b. The pound interest rate i is 10% and the exchange rate changes from $ 1.50 per pound to $ 1.38 per pound. c. The Swiss Franc interest rate is 2% and the Franc is expected tp remain stable with respect to US dollar 2. Suppose the dollar interest rate is 5% and the pound sterling interest rate is 10%, per annum. Suppose the expected exchange rate one year from now is $1,575 per pound. According to the UIP, what should be the current exchange rate? 3. Assume that the current exchange rate is 1,67$ per pound. The interest rate on USD deposits is 4% and on pound deposits is 8%, per annum. If covered interest parity holds, what is the one year USD per pound forward? 4. Assume that the interest rate parity holds; use relevant graphs to explain, how will the following changes affect the current exchange rate: a. An increase of the foreign interest rate b. A change to the expected exchange rate – the foreign currency is expected to depreciate by more than previously expected c. An increase in home interest rate d. A decrease in foreign money supply e. A decrease in Home’s output. 5. Assume that a trader can borrow 5 million PLN. The current exchange rate is 3.65 PLN per USD, and the 12 month forward is 3.75 PLN per USD. The interest rate is 5% per annum for PLN and 3% per annum for USD. Does the covered interest parity hold? How much can this trader earn? What will happen to current exchange rate? 6. Assume that the current exchange rate is 4.16 zlotys per euro, and the forward exchange rate in one year from now is 4.26 zlotys per euro. Polish interest rate is 3.2% per annum and the euro interest rate is 0.3% per annum. What is the risk premium, assuming that investors perceive the two assets as offering the same risk-adjusted rate of return? .