Question

Dallas Co. has determined that the interest rate on euros is 6 percent while the U.S. interest rate is 3 percent for one-year Treasury bills. The one-year forward rate of the euro has a discount of 5 percent. Does interest rate parity exist? Can Dallas achieve a higher effective yield by using covered interest arbitrage than by investing in U.S. Treasury bills?

Answer 1

Interest Rate Parity says that forward premium/discount on a currency should be equal to the interest rate differential between two countries i.e. higher interest rate currency will trade at discount, equal to the difference between the interest rates, and vice versa.

In this case, US Dollar has a lower interest rate compare to Euro. Therefore, as per Interest Rate Parity, Dollar will Appreciate, by 3%(approx) i.e. Euro will Depreciate by 3%(approx)

In given case, Euro is at a Discount of 5% which is NOT EQUAL TO 3%.

Therefore, Interest Rate Parity DOES NOT EXIST and Dallas CAN ACHIEVE HIGHER RETURN from Covered Interest Arbitrage then by investing in U.S. Treasury Bonds