Theory and Empiric of Interest Parity

1  Theory and Empirics of Interest Parity

State the uncovered and the covered interst parity conditions.

1.  Why is uncovered interest parity called uncovered?  Does it have to hold?  what assumptions are needed?  How does it compare to covered interest parity?

2.  The  USD  3-month  deposit  (interest)  rate  and  the  GBP  3-month  deposit  rate  are  both 5.0%.  What is the relationship between the current equilibrium USD/GBP exchange rate and its expected future level? Assume the expected USD/GBP exchange rate three months into the future remains constant at USD 1.50 per GBP. But the GBP 3-month deposit rate doubles to 10.0%.  What is the new spot USD/GBP exchange rate in equilibrium.

3.  Plot the difference between USA 3-Month Euro-dollar deposit rate and the UK 3-monthEuro-sterling deposit rate from January 2000 to December 2008.  What do you observe?Now plot the expected exchange rate change at the three month horizon for the USD/GBP exchange rate, assuming that investors have perfect foresight so that the expected exchange rate equals the future realized spot rate. Does Uncovered Interest Parity seem to be satisfied in the data?  Describe the steps you would have to take to check for covered interest parity in the data?


Please visit the Bank of England website: in order to downloadthe end of month USD/GBP spot exchange rate (symbol:  XUMLUSS),the end of month 3-month Euro-sterling deposit rate (symbol:  IUMES3A), the end of month 3-month Euro-dollar deposit rate (symbol:  IUMED3A), and the end of month USD/GBP 3-month Forward Rate (symbol:  XUMLDS3).  The deposit rates should be under “Overseas currency deposit rates (3 months)” in the “Wholesale interest and discount rates” category.  The spot exchange rate can be found under the “Spot exchange rates” category.  Be sure to select “against the sterling” header.  The forward rate can be found under the “Sterling against US dollar forward rates”category.  After you have made your selection click “ShowData”, which will lead you to a page so that you can download the data series in Excel format.

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