IAI Actuarial Core Principles · Business Economics · Balance of payments and exchange rates
Under uncovered interest rate parity, Indian one-year interest rates are 7% and US one-year rates are 3%, and investors are risk-neutral. The expected change in the rupee against the dollar over the year is closest to:
The rupee is expected to depreciate by about 4%. Under uncovered interest parity, expected returns equalise, so the currency with the higher interest rate is expected to lose value by roughly the interest differential of 7% minus 3%.
- ADepreciation of about 4%Correct
- BAppreciation of about 4%
- CAppreciation of about 10%
- DNo change
- Depreciation of about 10%
Explanation
With uncovered interest parity, the higher-interest currency is expected to depreciate by about the interest differential to equalise expected returns. The differential is 7% minus 3%, which is 4%. So the rupee is expected to depreciate about 4%. Appreciation would give Indian assets a higher return than the US ones, so that would violate the parity condition.
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