Economics: Uncovered Interest Rate Parity (UIP)

CIIA_Economics_Currency_UIP_Uncovered_Interest_Rate_Parity_Question_Solution

Question setup

In intro text:

„In September 2008 the US Fed fund rate was 2%, while one dollar bought 0.68 Euros.“

In question c)

„…bear in mind that the price of one dollar reached a peak of about 0.80 Euros in November 2008…“

Actual question

  1. Briefly present the uncovered interest rate parity (UIRP/UIP) equation, and then assuming that UIRP/UIP holds, exploit it to forecast the three months movement of the USD against the Euro from September to November 2008, bearing in mind that the ECB policy rate (min. bid rate on the main refi operations of the Eurosystem) was 4.25%. What can you conclude about your forecast knowing the USD/EUR movement in the period September-November 2008?

 

Solution

Note:

Sep 08: One Dollar bought 0.68 Euros = 1 USD = 0.68 EUR

Same as USD/EUR = 1 / 0.68 = 1.4706

Nov 08: One Dollar bought 0.80 Euros = 1 USD = 0.80 EUR

Same as USD/EUR = 1 / 0.80 = 1.2500

 

Dollar appreciated. (1.4706 – 1.2500) / 1.4706 = 15%

Euro depreciated.

 

Based on UIRP:

2.25% – 4.50% = -2.25% !!! This value is for a year. We’re looking to forecast the three month movement. So -2.25 * (3/12) = 0.5625% = 0.6%

 

Move in USD/EUR wasn’t consistent with the interest rate parity equation with respect to the magnitude of the FX move.

 

Notes:

 

Problems:

  1. Converting a given currency exchange rate
  2. Remembering that UIRP (UIP) gives a value for a year; and that period we’re looking at is shorter

 

 

Intuition for myself

Sep 08: One Swiss Franc bought 0.826 Euro = 1 CHF = 0.826 EUR

Same as CHF/EUR = 1 / 0.826 = 1.21

Same as EURCHF = 1 / 0.826 = 1.21

Nov 08: One Swiss Franc bought 0.95 Euros = 1 USD = 0.95 EUR

Same as CHF/EUR = 1 / 0.95 = 1.0526

 

Swiss Franc appreciated.

Euro depreciated.

 

 

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