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Question from core reading example 4
JPY/GBP Spot rate = 129.67
1 yr JPY Libor = 0.10%
1 yr GBP Libor = 3.00%
If uncovered IRP holds, what will be the JPY/GBP exchange rate after 1 year?
(A) 126.02 (B) 129.67 (C) 130.05
Book solution:
Expected(Spot) = Forward rate = 129.67(1.001/1.03) = 126.02
(Explanation given to this is: if uncovered IRP holds, then forward rate parity holds too). But how? I think this is not mandatory!
My approach 1:
If uncovered IRP holds, then expected percentage change in spot rate = interest rate differential (foreign interest – domestic interest), i.e., [(0.001-0.03)-1]*129.67 = 125.91 — Close to option (A), but not the exact value.
My approach 2:
If uncovered IRP holds, then the domestic currency must appreciate.
Option (B) — Spot rate unchanged — Eliminated
Option (C) — Spot rate increased — Domestic currency depreciated — Eliminated
Option (A) — Answer
Your logic is correct in approach 2 and for calculating the actual value institutes answer way is correct.