Homework Answers
The parity condition marked in "d" is known as the interest rate parity(IRP). IRP assumption suggest that forword spot differential is due to nominal rate differential between two countries.
If Nominal interest rate in two countries are different there will be flow of funds between two countries in the form of FPI and FDI.
Flow of funds will continue till the arbitrage gain exist. Flow of funds will stop when actual exchange rate becomes equal to theoretical exchange rate calculated according to IRP.
According to IRP
(1+ix)/(1+iy) = Fx/y/Sx/y
ix = interest rate in currency x
iy = interest rate in currency y
Fx/y = Forward exchange rate x/y
Sx/y = Spot exchange rate x/y
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