a) If the US nominal interest rate is 5 percent, the foreign nominal interest rate is3 percent, and

a) If the US nominal interest rate is 5 percent, the foreign nominal interest rate is3 percent, and the current nominal exchange rate (domestic currency price of foreign exchange) is 2, what is the equilibrium forward rate set by banks and the equilibrium forward premium according to covered interest rate parity?Explain your answer carefully.b) Assume that absolute purchasing power parity holds. If the domestic country inflation rate is 5%, and the rate of nominal exchange rate depreciation is 2%,what is the foreign countryâ€s inflation rate?c) Suppose asset A and asset B have equal expected returns, asset A has a variance of 2, asset B has a variance of 4, and the covariance between asset A and asset B is -6. If you are risk averse, and hold 50% of your portfolio in assetA and 50% in asset B, are you better off than if you hold asset A only?d) Suppose you discover that the dollar price of a Big Mac is $2.50 in the US, theUK pound price of a Big Mac is one pound and 50 pence, and the dollar price of a pound is 2. According to the law of one price, is the dollar overvalued or undervalued compared to the relative price of Big Macs? Is there any reason to expect the exchange rate – or the prices of Big Macs – to adjust? Why or why not?e) If the expected inflation rate is 5 percent, and the nominal interest rate is 2percent, what does the Fisher Equation tell you is the ex-ante real interest rate? What does this mean, exactly?f) If markets forecast that next monthâ€s dollar/pound exchange rate will be $2per pound, and the one month nominal interest differential between the US and UK is 10%, in an efficient market what should be the equilibrium nominal exchange rate be?

 

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