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interest rate parity concepts

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Define and explain the interest parity concept using formal methods Explain IS and LM curve behavior and nominal interest rate in the domestic economy, and then to the exchange rate between the domestic economy and the rest of the world in the following situations. A weaker currency means it takes fewer foreign currency units to buy the domestic currency. (1) the domestic government increases spending 2) the domestic central bank decreases the money supply, 3) the foreign central bank increases.

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Interest rate parity implies that the domestic interest rate is equal to the foreign rate less the forward premium. The forward premium is the expected change in the exchange rate. This gives you a simple rule: if the domestic interest rate is above the foreign rate by x%, the forward exchange rate (for the maturity equivalent to the interest rate) will be less than the spot rate by x%. Lower interest rates yield higher exchange rates, which equalizes investments. If domestic interest rates exceed foreign, then the domestic currency should depreciate against the foreign by an amount that prevents arbitrage.

The slope of the LM curve is determined by k (the income elasticity of money demand) and h (the interest elasticity of money demand). Higher k implies steeper LM, higher h implies flatter LM. The LM curve slopes upward, ...

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Arbitrage, Interest Rate Parity and Forecasting Exchange Rates

Respond to following statements.
1. Explain the concept of locational arbitrage and the scenario necessary for it to be plausible.
Locational arbitrage can occur when the spot rate of a given currency varies among locations, specifically the ask rate at one location must be lower than the bid rate at another location. The disparity in rates can occur since information is not always immediately available to all banks. If a disparity does exist, locational arbitrage is possible as it occurs the spot rates among locations should become realigned. Arbitrage can be defined as the act of simultaneously buying and selling the same assets or commodities for the purpose of making certain guaranteed profits. As long as there are profitable arbitrage opportunities, the market cannot be in equilibrium.
2. Explain the concept of locational arbitrage and the scenario necessary for it to be plausible.
Locational arbitrage exists when an investor attempts to exploit discrepancies in exchange rates between banks. Locational arbitrage occurs when exchange rates are not in equilibrium. These are relatively short time periods with which experienced investors look for in order to make a profit just by selling one currency for another for a period of time. The rise and fall of interest rates, spot rates and forward market rates generally bring the exchange rates back into equilibrium relatively quickly.
3. how would you explain the concept of interest rate parity? Please provide the rationale for its possible existence.
4. Explain the fundamental technique for forecasting exchange rates. What are some limitations of using a fundamental technique to forecast exchange rates?
The fundamental technique for forecasting exchange rates would be constructed on the fundamental relationships between economic variables and exchange rates. The use of PPP to forecast future exchange rates in inadequate since PPP may not hold and future inflation rates are also uncertain. Given these relationships, a change in one or more of these variables or a forecasted change in them will lead to a forecast of the currency's value. A company may be motivated to forecast exchange rates to help them to decide whether to hedge foreign currency cash flows, to decide whether to invest in foreign projects, to decide whether foreign subsidiaries should remit earnings, or to decide whether to obtain financing in foreign currencies.
The numerous methods available for forecasting exchange rates can be categorized into four general groups, technical, fundamental, market-based, and mixed. Fundamental forecasting is limited by the uncertain timing of the impacts of the factors, the need to forecast factors that have an immediate impact on exchange rates, the omission of factors that are not easily quantifiable, and the changes in the sensitivity of currency movements to each factor over time.

5. Explain the fundamental technique for forecasting exchange rates. What are some limitations of using a fundamental technique to forecast exchange rates?
There are many approaches that can be used to forecast exchange rates. These can vary from efficient market approach, fundamental approach, or even technical approach. Not all approaches should be treated with the same validity for every situation. Personally I think the random walk hypothesis is one of the better models to use as today's outcome is a good basis as to what tomorrow's outcome could possibly be. There is the notion that exchange rates should not follow and random walk as it doesn't make much sense as to why they would.
The fundamental technique does have many limitations such as its use of historical data could be wrong if economic or governmental forces change within a country, the model itself could just be wrong altogether, or even forecasting is difficult and things can just be wrong. This approach relies on inputs from other models and data so this data needs to be scrutinized to ensure its validity.

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