Question 3

(A) Answer the following parts (i) and (ii). Please note that part (ii) uses the answer from part (i).

1. (i) If the interest rate is 6% on euro deposits and 3% on dollar deposits, while the euro is trading at $1.40 per euro, what does the market expect the exchange rate to be one year from now assuming the Interest Parity Condition holds? Show all your work and provide explanation. [15%]

2. (ii) If the dollar begins trading at $1.40 per euro, with the same interest rates given in part (i) above, and the ECB (European Central Bank) raises interest rates so that the rate of the euro deposits rises by 2%, what will happen to the exchange rate, assuming that the expected future exchange rate remains the same as you estimated in part (i)? Show all your work and provide explanation. [15%]

(B) Explain the innovations in Basel III relative to Basel II after the 2007-2008 global financial crisis. [10%]