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Spot acrate based on covered interest parity

The spot exchange rate between the U.S. dollar and the German mark is $.5500/DM. The dollar deposit rate is 8 percent and the DM deposit rate is 4 percent.

a. What is covered interest parity? What is the six-month forward rate if covered interest parity holds?

b. What is the unbiased forward rate hypothesis? If the unbiased forward rate hypothesis holds, what do you expect the spot rate between the U.S. dollar and the German mark to be in six months?

I am confused on both parts of this question. Need detail guidance on how to answer this question. Thank you.

Solution Preview

a. Interest parity means that the forward rates of the currency with lower domestic interest rates would be at a premium in relation to a currency at a higher interest rate. In covered interest parity the forward premium would be equal to the interest rate differentials. If this is not the case there would be opportunity for arbitrage. To take the given example of US dollar and German mark. The interest rate in US is higher than the interest rate in Germany. Interest rate parity means that in the forward market, the ...

Solution Summary

The solution has two problems dealing with covered interest rate parity and unbiased forward rate hypothesis