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FRM Part I · FRM Exam Part I · Foreign Exchange Markets

Under uncovered interest rate parity, the one-year USD interest rate is 5% and the one-year EUR interest rate is 3%. The current spot rate is USD 1.10 per EUR. Using the approximate relationship, what does UIP imply about the expected change in the EUR against the USD over the year?

The EUR is expected to appreciate by about 2%. UIP implies the higher-yielding currency, here the USD at 5% versus 3%, is expected to depreciate by the interest differential, so the EUR gains roughly 2% against the USD over the year.

  1. AEUR expected to appreciate by about 2%Correct
  2. BEUR expected to depreciate by about 2%
  3. CEUR expected to appreciate by about 8%
  4. DEUR expected to remain unchanged

Explanation

UIP says the currency with the higher interest rate is expected to depreciate by the interest differential. The USD rate is 2% higher than the EUR rate, so the USD is expected to depreciate and the EUR to appreciate by about 2%. Option B reverses the direction. Option C adds the rates instead of subtracting.

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