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II. Consider two bonds, one issued in euros () in Germany, and one issued in dollars (S) in the United States. Assume that both government securities are one-year bonds-paying the face value of the bond one year from now. The exchange rate, E, stands at 0.75 euros per dollar. The face values and prices on the two bonds are given by Face Value $10,000 10,000 Pric S9,615.38 9,433.96 United States Germany a. Compute the nominal interest rate on each of the bonds. b. Compute the expected exchange rate next year consistent with uncovered interest parity. c. If you expect the dollar to depreciate relative to the euro, which bond should you buy?d. Assume that you are a U.S. investor and you exchange dollars for euros and purchase the German bond today. One year from now, it turns out that the exchange rate, E, is actually 0.72 (.72 euros buy one dollar). What is your realized rate of return in dollars compared to the realized rate of return you would have made had you held the U.S. bond? e. Are the differences in rates of return in (d) consistent with the uncovered interest parity condition? Why or why not? Explain

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Next, we will calculate the nominal interest rate on the German bond which has a face value of $10,000 and a price of $9,433.96. $10,000 $9,433.96 r 1.060- x 0.06 or 6% he nominal interest rate on the German bond is 6% (b) To calculate the expected exchange rate for next year we will need to reorganize the interest parity relation given in the book. By reorganizing this equation we can isolate the expected exchange rate and solve for it. We will begin at equation 18.2 in the book as written below r+l r+l 1+iNote that the work above is merely isolating the term for the expected exchange rate. First, we move this term to the left side of the equation, then we move the other term (1+i) to the right side of the equation. This allows us to solve for the expected exchange rate. Now that we have the equation figure out the expected exchange rate we can plug in the numbers we have. As determined in part (1), the nominal interest rate for German bonds () is 0.06 and the nominal interest rate for bonds () is 0.04. Also given in the problem is the current exchange rate (Et) which is 0.75. We can just plug these numbers into the equation to come up with our answer 1+1 1.06 1.04 r+1 E 0.75(1.019) Ее,-0.764(c) If you expect the dollar to depreciate relative to the euro you should buy the euro bond since it pays a higher interest rate. Since the euro bond pays 6% interest rate while the bond pays 4% interest rate, purchasing the bond would yield a smaller payout. (d) To determine the realized rate of return in dollars if you invest in German bonds compared to the realized rate of return if you held the bonds we need to use the uncovered interest parity. This states that we will multiply the German bond rate by the quotient of this years exchange rate and the expected exchange rate for next year .75 .72 ,-1.104-1 ,1014 he realized rate of return is 10.14% (e) The difference in rates of return is consistent with the uncovered interest parity condition. The difference in these two rates is consistent because the uncovered interest parity condition only regarded the equality of expected returns but not necessarily the equality of realized returns. This means that the uncovered interest parity condition ignores all risks, This means that the uncovered interest parity condition ignores all risksthus the expected returns can differ from the realized return if conditions change

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