Ss4. Reading 13. BB.ex.4
Could someone please explain the answer.
Ss4. Reading 13. BB.ex.4
Could someone please explain the answer.
If random walk then the value at time t+1 will equal the value from t (plus an error).
Spot rate one year from now will equal spot rate today in the example - hence random walk.
Thanks. Could u also tell me q2 in this same example 4.
I had to look at the answer because I would have chosen answer A.
The way I understand it: arbitrage will force the covered interest rate parity to hold, there is no condition (rule whatever) to make the uncovered interest rate parity to hold.
So the future exchange rate will be calculated by the equation spot x price currency interest rate / base currency interest rate and not with the difference in the interest rates.
But do not rely 100% on my explanations as I’m not an economist myself.
You do take the difference in rates into account by taking the ratio too.
Why would it not be an arbitrage… if the prediction doesn’t come true then wouldn’t traders actually take advantage and earn a higher yield?
I see your point, again I’m not an economist. The way I understood it:
If UIP holds it means the currency with the lower interest rate would have to appreciate vs the other.
CIP means the stronger currency (the one with the lower interest rate) will trade at a forward premium.
CIP is enforced by arbitrage so this must happen.
UIP is not enforced by arbitrage, the lower interest rate currency will not necessarily appreciate vs the other.
Somewhere in the curriculum around this BB there is an explanation, please look at it.
Once again (because my kid is destroying my desk in the meantime):
Covered IP will hold because otherwise there is arbitrage so it will be enforced by arbitrage.
Uncovered IP will not hold because there are no trades on the differences of the interest rates (or this is what the book writes) only trades with spots and forwards which are built on the CIP.