Asked by David Thibodeaux-Benoit on Jun 19, 2024
Verified
Suppose that the spot rate on the U.S. dollar is C$.91. The risk-free nominal rate in the U.S. is 8 % while it is only 4 % in Canada. Which one of the following one-year forward rates best establishes the approximate interest rate parity condition?
A) C$.8678
B) C$.8736
C) C$.8855
D) C$.9056
E) C$.9212
Interest Rate Parity
A theory which says that the difference between the interest rates of two countries is equal to the differential between the forward exchange rate and the spot exchange rate of their currencies.
Forward Rates
The predetermined interest rates or currency exchange rates agreed upon for transactions that will be executed at a future date.
Spot Rate
The existing market cost at which a certain asset is offered for buy or sell, ensuring immediate delivery.
- Gain an insight into the theory of interest rate parity and what it means for forward rate adjustments.
Verified Answer
RA
Renee AvrutinJun 21, 2024
Final Answer :
B
Explanation :
The interest rate parity condition suggests that the forward rate should adjust to offset the interest rate differential between two countries, preventing arbitrage. The formula to calculate the forward rate based on interest rate parity is: Forward Rate = Spot Rate * (1 + Interest Rate Domestic) / (1 + Interest Rate Foreign). Plugging in the given values: Forward Rate = 0.91 * (1 + 0.08) / (1 + 0.04) = 0.91 * 1.08 / 1.04 ≈ 0.8736.
Learning Objectives
- Gain an insight into the theory of interest rate parity and what it means for forward rate adjustments.