Interest Rate and Exchange Rate
The objective of this assignment is to help you understand the relationship between interest rate and exchange rate in the real world.
To do this assignment, select any two countries and download the following data:
1. Monthly data for ten years on interest rates of the two countries and exchange rate between their currencies
2. Quarterly data for ten years on interest rates of the two countries and exchange rate between their currencies
Use the data to study interest parity condition and relationship between interest rates differential and exchange rate.
Interest rate parity
Take interest rate of one of the two countries as domestic deposit rate and the interest of the other country as foreign deposit rate. Determine whether the interest rate parity exists between the countries using the following equation:
IRP = RL – RF + (EeL/F– EL/F)/EL/F
Find interest rate parity for each month and each quarter in monthly and quarterly data respectively. Plot and graph the results using bar chart. Analyze interest rate parity conditions observed in the data.
Interest rate and exchange rate
For each moth and quarter, find difference between domestic and foreign rates. Plot the interest rate differential on the exchange rate between countries and evaluate the relationship between them. Observe any trends in the comovement of the data series.
What to submit?
Prepare a comprehensive report containing the following:
1. A brief summary of the descriptive statistics of the data series—interest rates, exchange rate, and interest rate differential. The descriptives should include: minimum, maximum values, range, and standard deviation.
2. Analyze interest rate parity condition and relationship between interest differential and exchange rate. Explain any observed trends.