In our lecture we first learn how UIP arbitrage drives the spot rate to its equilibrium level given domestic interest rate, foreign interest rate, and expected spot rate. After that, we introduce CIP arbitrage that drives the forward rate to its equilibrium level, given the UIP equilibrium spot rate, domestic interest rate, and foreign interest rate. In reality both UIP

arbitrage and CIP arbitrage can and do occur simultaneously whenever deviations occur.

Starting from both UIP and CIP conditions initially, let there be a shock to the expected spot rate, E$^($e$)$uarr$.$ This shock leads to deviation from UIP and triggers UIP arbitrage which generates a depreciation pressure on the spot rate. However, the deprecation of spot rate creates CIP deviation and triggers CIP arbitrage which generates an appreciation pressure on the spot rate. With UIP arbitrage and CIP arbitrage exerting opposite effects on the spot rate, it is not immediately clear how the adjustment process proceeds and how the spot and forward rates adjust to their new equilibrium. Please explain very clearly the adjustment process to the new UIP and CIP equilibrium after the shock to E$^($e$).$

Note: In this question, we assume that domestic and foreign interest rates remain the same, and the expected spot rate stay at the new level after the shock.