Question

4. Interest rate parity The rise of globalization is due to the many companies that have become multinational corporations for various reasons-for example, to access better technology, to enter new markets, to obtain more raw materials, to find funding resources, to minimize production costs, or to diversify business risk. This multimarket presence exposes companies to different kinds of risk as well-for example, political risk and exchange rate risk. The relationship between interest rates and exchange rates can be represented through the concept of interest rate parity. Consider the following: An American investor is considering investing $1,000 in default-free 90-day Japanese bonds that promise a 5% annual nominal return. • The spot exchange rate is ¥101.12 per dollar. • The 90-day forward exchange rate is ¥100.25 per dollar. The investor's annualized return on these bonds-if he or she can lock in the dollar return by selling the foreign currency in the forward market-will be 8.942% invl 6 3870 inv 9.793% arity recognizes that when you invest in a country other than your home country, two factors affect your investment-returns on the elf and changes in the exchange rate. Which of the following would cause the overall return on your investment to be lower than the tated return? 8516% Ir home currency depreciates relative to the currency in which the investment is denominated. The currency in which the investment is denominated appreciates relative to your home currency. O Your home currency appreciates relative to the currency in which the investment is denominated.

Answer 1

Interest rate parity:

As per Interest rate parity the difference in spot fate and forward rate exits due to differences in interest rate between two countries.

F/S = (1+ra)/(1+rb)
F= forward rate 100.25¥/$
S = spot rate. 101.12
ra = interest rate of Japan for 90 days (0.05/4)
rb= interest rate of dollar currency ?

(100.25/101.12)= 1.0125/(1+rb)

rb(90days) = 0.0212867
Rb(annual)= 0.08515 = 8.515%

Answer: 8.516%

Answer:
If your home currency appreciates relative to the currency in which investment is denominated.

Explanation:
Because it becomes costly to buy back home currency as it appreciates and hence lowers the return.