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Questions and Answers

Which concept is closely related to the failure of uncovered interest parity to hold?

  • Forward rate bias puzzle
  • Time-varying risk premium
  • Long-run UIP relationship
  • Forward premium puzzle (correct)

    • What does uncovered interest parity state regarding the forward discount and the ex post change in the spot rate?

  • They are unrelated
  • They are unpredictable
  • They should be in the same direction
  • They should be in opposite directions (correct)

    • What is the error term in the equation that relates the spot rate, forward rate, and expectation of the spot rate?

  • Expectational error (correct)
  • Serial correlation
  • Regression error
  • Rational expectations hypothesis

    • What does covered interest rate parity maintain regarding domestic and foreign money market investments?

    <p>They have the same return</p> Signup and view all the answers

    Which one of the following accurately describes Covered Interest Parity (CIP)?

    <p>CIP states that the forward premium of a foreign currency should be equal to the interest rate differential between a domestic asset and a substitutable foreign asset.</p> Signup and view all the answers

    Which one of the following accurately describes Covered Interest Arbitrage?

    <p>Covered interest arbitrage is the transfer of liquid funds from one monetary center to another to take advantage of higher rates of return or interest, while covering the transaction with a forward currency hedge.</p> Signup and view all the answers

    Suppose the 3-month T-bill rate in the U. S. is 12%, higher than the 3-month T-bill rate of 8% in Canada. If the spot exchange rate is 1.00CAD/USD at present, and the 3-month forward exchange rate is 0.99CAD/USD at present, what is the expected return from covered interest arbitrage in 3 months?

    <p>4%</p> Signup and view all the answers

    What is CIP based on?

    <p>The assumption that the forward market is used to cover against exchange risk</p> Signup and view all the answers

    What is UIP based on?

    <p>The assumption that transactions are conducted only in the current market</p> Signup and view all the answers

    Why is it important to study UIP's potential validity/failure?

    <p>To ensure the effectiveness of interest rate policy to stabilize an exchange rate</p> Signup and view all the answers

    What are the results of empirical UIP studies?

    <p>UIP is always tested in a form of equality between realized change in spot exchange rate and interest rate differential</p> Signup and view all the answers

    What is the forward premium puzzle closely related to?

    <p>The failure of uncovered interest parity to hold</p> Signup and view all the answers

    What does uncovered interest parity state regarding the forward discount and the ex post change in the spot rate?

    <p>The forward discount should be an unbiased predictor of the ex post change in the spot rate</p> Signup and view all the answers

    What is the unbiasedness hypothesis?

    <p>There is no systematic difference between the forward rate and the expected future spot rate</p> Signup and view all the answers

    What do regression estimates find regarding the regression coefficient in the equation relating the spot rate, forward rate, and expectation of the spot rate?

    <p>The regression coefficient is often not statistically significantly far from unity</p> Signup and view all the answers

    Which one of the following accurately describes Covered Interest Parity (CIP)?

    <p>CIP states that the forward premium of a foreign currency should be equal to the interest rate differential between a domestic asset and a substitutable foreign asset.</p> Signup and view all the answers

    What is Covered Interest Arbitrage?

    <p>Covered interest arbitrage is the transfer of liquid funds from one monetary center to another to take advantage of higher rates of return or interest, while covering the transaction with a forward currency hedge.</p> Signup and view all the answers

    Suppose the 3-month T-bill rate in the U. S. is 12%, higher than the 3-month T-bill rate of 8% in Canada. If the spot exchange rate is 1.00CAD/USD at present, and the 3-month forward exchange rate is 0.99CAD/USD at present, what is the expected return from covered interest arbitrage in 3 months?

    <p>4%</p> Signup and view all the answers

    What is the relationship between Covered Interest Parity (CIP) and the forward market?

    <p>CIP is based on the assumption that the forward market is used to cover against exchange risk</p> Signup and view all the answers

    What is the main difference between Covered Interest Parity (CIP) and Uncovered Interest Parity (UIP)?

    <p>CIP assumes transactions are conducted in both current and forward markets, while UIP assumes transactions are conducted only in the current market</p> Signup and view all the answers

    Why is it important to study the potential validity/failure of Uncovered Interest Parity (UIP)?

    <p>All of the above are reasons to study the potential validity/failure of UIP</p> Signup and view all the answers

    What are the possible explanations for deviations from Covered Interest Parity (CIP)?

    <p>Transaction costs, possible capital controls, and difference in tax rates on interest income and foreign exchange losses/gains in different countries</p> Signup and view all the answers

    Study Notes

    Uncovered Interest Parity (UIP)

    • The failure of UIP to hold is closely related to the concept of the unbiasedness hypothesis
    • UIP states that the forward discount is equal to the expected change in the spot rate
    • The error term in the equation relating the spot rate, forward rate, and expectation of the spot rate represents the deviation from UIP

    Covered Interest Parity (CIP)

    • CIP maintains that the returns from domestic and foreign money market investments should be equal when hedged against exchange rate risk
    • CIP is based on the no-arbitrage condition in the forward market
    • CIP describes the relationship between the spot rate, forward rate, and interest rate differential between two countries

    Covered Interest Arbitrage

    • Covered Interest Arbitrage is a risk-free investment strategy that takes advantage of deviations from CIP
    • It involves borrowing in a country with a low interest rate, investing in a country with a high interest rate, and hedging the exchange rate risk through a forward contract
    • The expected return from covered interest arbitrage is the difference between the interest rates in the two countries, adjusted for the forward discount

    Empirical Studies

    • Empirical studies on UIP have found that the regression coefficient in the equation relating the spot rate, forward rate, and expectation of the spot rate is often less than one, indicating deviations from UIP
    • The results of empirical UIP studies have implications for the forecasting of exchange rates and the management of foreign exchange risk

    Forward Premium Puzzle

    • The forward premium puzzle is closely related to the failure of UIP to hold
    • It refers to the phenomenon where the forward discount is not equal to the expected change in the spot rate

    Importance of Studying UIP and CIP

    • It is important to study the potential validity/failure of UIP and CIP because they have implications for the forecasting of exchange rates and the management of foreign exchange risk
    • Understanding UIP and CIP can help investors and policymakers make informed decisions about investments and monetary policy

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    Related Documents

    Covered and Uncovered Interest Parites PDF

    Description

    Test your knowledge on Covered and Uncovered Interest Parities (CIP) with this quiz. Learn about the no-arbitrage condition and how it relates to interest rate differentials and financial assets in different currencies.

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