1
Brigham Young University Department of Economics
Economics 459  International Monetary Theory
Dr. Phillips (section 1) Fall Semester 2009
Tuesday & Wednesday, October 27 & 28, 2009
Midterm Exam key
1.
Given the following estimated regression of the actual percent change in the spot exchange rate on
the forward premium from the previous period,
ߝ
௧
ൌ .10 െ .33߮
௧ିଵ
ݑ
௧
, write down an investment rule
that would make money on average.
Explain why this strategy would work.
Show how to implement this
rule on the data provided.
Show whether one should take a short or long position.
Also show the expected
and actual returns from doing so.
The return on a short investment is
∆
ൌ
ି
െ
which is the same as
∆
ൌ
ି
െࢿ
.
Note this
is also the negative of the return on a long investment.
Using the regression equation above this
gives,
∆
ൌ
ି
െ ሺ. െ.
ି
ሻ
.
So the expected value of the return on a short investment is
∆
ൌ .
ି
െ.
.
Hence if,
ି
.
.
a short investment will have a positive expected return.
If
ି
൏
.
.
, it will have a negative expected return, but this means a long investment would have a
positive expected return.
The rule is:
If
ି
.
.
take a short position, otherwise take a long position.
period spot
forward
φ
short or long
expected return
actual return
1
2.33
2.14
8.51%
long
n/a
n/a
2
2.15
2.20
2.30%
long
21.31%
0.47%
3
2.24
2.35
4.79%
long
6.94%
1.80%
4
2.41
2.35
n/a
n/a
3.62%
2.52%
2.
Explain the difference between covered interest rate parity and uncovered interest rate parity.
Which hypothesis is more likely to be true in the real world?
Why?
Covered interest rate parity (CIRP) says that the expected return on a domestic investment should be
the same as the expected return on a covered foreign investment, where “covered” means future
exchanges of foreign currency for home currency are done at today’s forward exchange rate
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 Winter '08
 Phillips,K
 Economics, Exchange Rate, Purchasing Power Parity, Arbitrage, Foreign exchange market

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