Asked by Brynn Lauman on May 01, 2024
Verified
Let RUS be the annual risk-free rate in the United States, RUK be the risk-free rate in the United Kingdom, F be the futures price of $/BP for a 1-year contract, and E the spot exchange rate of $/BP. Which one of the following is true?
A) If RUS > RUK, then E > F.
B) If RUS < RUK, then E < F.
C) If RUS > RUK, then E < F.
D) If RUS < RUK, then F = E.
E) There is no consistent relationship that can be predicted.
Annual Risk-free Rate
The return on investment expected from a risk-free asset over a one-year period.
Futures Price
The agreed price for the future delivery of an asset in a futures contract market.
Spot Exchange Rate
The current exchange rate at which one currency can be traded for another immediately.
- Pinpoint and evaluate the fitting futures prices to preclude arbitrage prospects through the analysis of interest rate variances and exchange rate fluctuations.
Verified Answer
VF
Vanesia FrenchMay 01, 2024
Final Answer :
C
Explanation :
The correct answer is based on the Interest Rate Parity (IRP) theory, which states that the difference in the national interest rates for financial instruments of similar risk and maturity should be equal to the forward exchange rate differential for currencies. Therefore, if the US risk-free rate is higher than the UK's, it implies that the future value of the US dollar is expected to be lower relative to the British pound, leading to a higher future price (F) compared to the current spot rate (E), hence E < F.
Learning Objectives
- Pinpoint and evaluate the fitting futures prices to preclude arbitrage prospects through the analysis of interest rate variances and exchange rate fluctuations.