Suppose that the one-year interest rate is 5.0 percent in the United States and

Question

Suppose that the one-year interest rate is 5.0 percent in the United States and 3.5 percent in Germany, and that the spot exchange rate is $1.12/ and the one-year forward exchange rate, is $1.16/. Assume that an arbitrageur can borrow up to $1,000,000. Question 32 options This is an example where interest rate parity holds This is an example of an atinge opportunity: interest rate parity does NOT hold This is an example of a Purchasing Power Parity violation and an arbitrage opportunity None of the above. words. 1446of 100% 23 esc 30 FI OOD FA F2 F5 F6

Explanation / Answer

The interest rate parity relates the spot exchange rate, forward exchange rate and nominal exchange rates of two countries.

Interest rate parity equation -

(Forward Exchange rate / Spot exchange rate) = [1+ Rf(US)]/[1+Rf(Germany)]

Where,

Forward Exchange rate = $1.16/€

Spot exchange rate = $1.12/€

One year risk-free interest rate in Germany Rf (Germany) = 3.5% per annum

One year risk-free interest rate in United States Rf(US) = 5%

Therefore, if interest rate parity holds then following equation should be in equilibrium

$1.16/$1.12 = [1+ 5%]/ (1+3.5%) = (1.05 / 1.035)

But

1.03571 ? 1.01449

Equation is not in equilibrium.

Therefore interest rate parity does NOT hold and there is an arbitrage opportunity.

Therefore correct answer is option: This is an example of an arbitrage opportunity, interest rate parity does NOT hold.

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