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Practice Problems 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
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