ECO365 - Topic 1
1. (a) What is the exact Uncovered Interest Parity (UIP) condition? Explain why this condition
must hold if the foreign exchange market is in equilibrium.
(b) Derive the exact UIP condition.
(c) What is the approximate UIP condition?
(d) Derive the approximate UIP condition from the exact UIP condition.
2. Consider the following situation. There are three currencies, Canadian dollar (CAD), US
dollar ($) and Japanese yen (Y) and their exchange rates are as follows : CAD 1 = $ 2, $1 = Y
2, CAD 1 = Y 3. Assume that an investor can carry out at most three transactions.
(a) If an investor in Canada has CAD 30, can he make proﬁt through arbitrage? What will be
his trading strategy? How much proﬁt will he make? (4 points)
(b) Now suppose the investor does not have any money. But he can borrow CAD from the bank
by paying 30% interest rate, i.e., whenever he returns the money, he has to pay 30% interest
rate. He cannot, however, earn any interest if he deposits CAD in the bank. Will he borrow
money to trade in currencies?
(c) Consider the same scenario as in (b). But now the bank raises interest rates to 40%. Will he
still borrow money to trade in currencies?
(d) Consider the same scenario as in (a). But now assume that the U.S. Treasury intervenes in
the foreign exchange market. In particular, the Treasury bans the selling of yen for $. Will the
investor continue to make arbitrage proﬁts? Will your answer change if, in stead, the Treasury
banned the buying of yen?
(e) Assuming that th