2) Exchange rates and interest rates are connected through the parity conditions. Let the New Zealand interest rate be 5% per annum, the US interest rate be 10% per annum, the spot exchange rate be 0.8USD/1 NZD, and the one year forward exchange rate to be 0.85USD/1 NZD.

a) What is the return, in NZD, a New Zealand financial trader would get if they invested 1 NZD in New Zealand?

b) What is the return, in NZD, an New Zealand financial trader would get if they invested 1 NZD in the US? [Hint: you'll have to exchange that NZD for USD!]

c) As you should find, the values given mean the parity condition does not hold. Given the interest rates are fixed, what will happen to the value of the spot exchange rate now? Think about this in terms of demand and supply for the NZD in the FOREX market, and you may draw out a diagram if you wish.

d) Now repeat c) for the change in value of the forward exchange rate.