Question

Suppose that the annual rate of returns on dollar deposits equals 3%, and the rate of return on euro deposits is 1%. Furthermore, assume that the current exchange rate is $0.9=1 euro. Find the expected exchange rate where interest parity holds.

Answer 1

Answer: The expected exchange rate where interest parity holds is approximately $0.9237 = 1 euro.

Explanation: To find the expected exchange rate where interest parity holds, we can use the interest rate parity equation:

(1 + i${USD}$) = (1 + i${EUR}$) * (E${euro/USD}$ / E${euro/USD}$)

Where:

i${USD}$ = annual rate of return on dollar deposits = 3%

i${EUR}$ = rate of return on euro deposits = 1%

E$_{euro/USD}$ = current exchange rate = $0.9 = 1 euro

Plugging in the values, we have:

(1 + 0.03) = (1 + 0.01) * (E$_{euro/USD}$ / $0.9)

Simplifying the equation:

1.03 = 1.01 * (E$_{euro/USD}$ / $0.9)

Dividing both sides by 1.01 and multiplying by $0.9:

E$_{euro/USD}$ = 1.03 * $0.9 / 1.01

E$_{euro/USD}$ = 0.9237