IMPORTANT HINTS FOR PROBLEMS

A. FORMULAS

1. Power Purchasing Parity

Expected exchange rate ( ¿ one year )=spot exchang rate ×

[ 1+ Inflation ¥
1+ Inflation $ ]
Exchange rate: Yen/USD (¥/$)

2. Interest rate Parity

Expected exchange rate

S 1−S2 $ ¥
×100=i −i
S2

S1: current exchange rate

S2: expected exchange rate

Exchange rate: Yen/USD (¥/$)

Forward rate

Forward rate ( 90 days )=spot rate ×

[ 1+i ¥ ×
90
360 ]
[ $
1+i ×
90
360 ]
Exchange rate: Yen/USD (¥/$)

The forward premium or forward discount

spot exchange rate−forward rate 360

forward premium= × × 100
forward rate days

B. PROBLEMS

1. The Covered Interest Arbitrage (CIA): The investor will buy the forward rate to hedge his
investment
- Caculate the difference in interest rates (one-year) (in absolute value)

- Caculate the forward premium (in absolute value)

- Compare the difference in interest rates with the forward premium

If the difference in interest rates is greater than the forward premium/discount, invest in the
higher interest yielding currency.

If the difference in interest rates is less than the forward premium, invest in the lower yielding
currency.

2. The Uncovered Interest Arbitrage (UIA): The investor will NOT buy the forward rate, so
the forward rate is not available.

- Caculate the difference in interest rates (one-year) (in absolute value)

- Caculate the expected exchange rate (in absolute value)

spot exchange rate−expected exchange rate $ ¥

×100=i −i
expected exchange rate

Exchange rate: Yen/USD (¥/$)

- Calculate the expected change in the spot rate

Spot−the expected exchange rate 360

Expected change= × × 100
the expected exchange rate days

- Compare the difference in interest rates with the expected change in the spot rate

If the difference in interest rates is greater than the expected change in the spot rate, invest in the
higher interest yielding currency.

If the difference in interest rates is less than the expected change in the spot rate, invest in the
lower yielding currency.