ECO365 - Topic 1
1. (a) Exact UIP : (1 +Hi ) = (1 + F E . You must explain why, if this condition does not
hold, there would be arbitrage opportunities.
(b) Refer to class notes.
(c) Approximate UIP : i = i + E ▯E
H F E
(d) The exact UIP can be re-written as:
E ▯ E
1 + iH = (1 + iF)( + 1)
E ▯ E E ▯ E
= 1 + iF+ + iF
For two develop countries, exchange rate ﬂuctuations are usually quite small - for example,
0.05. At the same time, interest rates are also low - for example, 0.02. Hence, the product of
these two terms would be really small - for example, 0.001. By ignoring this term, i.e., setting
iF E ▯ 0, we get the approximate UIP.
2. (a) Yes, he can make proﬁt. He should sell CAD for $, then $ for Y, and ﬁnally Y for CAD.
He will make a proﬁt of CAD 10.
(b) The return of return