Interest rates and exchange rates (the details will be shown in Assignment

Interest rates and exchange rates (the details will be shown in instruction) - Assignment Example This is mainly because of the indifference of the investors. When the interest rate parity is covered, the interest rates and the forward exchange rate between two countries will be in equilibrium. This means that in such equilibrium, each unit return of home currency will be equal to the foreign currency. Thus, the covered interest rate parity states that the forward premium and the interest rate between two countries are equal and there will be no opportunity for arbitrage (Wang, 2009, pp.49-56). (Source: Dollery, University of Hull) The application of covered interest parity is that when it holds true, an investor will be indifferent of investment choice between two countries. For instance, if a French investor has the choice of either to invest or deposit in â‚ ¬ or $ then under CIRP, the investor will get same return irrespective of choice of currency. This is because in equilibrium the future value of investment or deposit will be same for both the currencies (Johann, 2008, p.10). Additionally, there will not be any scope for making profit due to the condition of no-arbitrage in CIRP (Gandolfo, 2002, pp.43-45). The covered interest rate parity is represented by the following equation: (1 + r$) = Ft/St x (1 + râ‚ ¬) Where, Ft = forward exchange rate during time‘t’; & the left hand side of the equation shows that dollar deposits return is equal to euro deposits the returns (Ullrich, 2009, pp.19-22). 2. Uncovered Interest Rate Parity (UIRP) – Investment in First Country The interest rate parity assumes that investors are willing to exchange foreign assets with domestic assets and vice-versa when there is opportunity of making profit from transactions. The theory also assumes that the assets are identical and hence perfect substitutes (Clark, 2002, pp.72-75). On the basis of this assumption it can be said that the investors will be willing to hold assets that yields superior returns irrespective of the origin country. This means that any random investor’s choice of investment decision will not be influenced by forward rates since the investor will earn equal returns on either option. This is because of the interest rate parity theory discussed earlier which assumes that there is no opportunity for arbitrage and the returns of domestic assets will be equal to that of foreign asset (Baillie and McMahon, 1990, pp.150-159). When the investor do not use the forward contract to hedge exchange rate fluctuations and the interest rate parity holds true (no opportunity for arbitrage), then the IRP is said to be uncovered (Harvey, 2008, p.90). The significance of uncovered interest rate parity is that it helps to determine the spot exchange rate by using the concept that expected changes in spot rate of two countries is equal to their interest rate differential (Melvin and Norrbin, 2012, p.115-119). a) Expected Exchange Rate Three Months from Birthday For the purpose of the study, the interest rates based on three month treasury bonds and changes in the interest rates were collected on daily basis. The exchange rates were extracted are the daily close price of exchange rates taken on the