Question

Nominal Country Forward Inflation rate Exchange rate differential interest rate CHF 1.5% нKD 3.5% Differential: Based on the information contained in the table above, the Interest Rate Parity is indicated by е f

Answer 1

Ans. g

Interest Rate Parity:

Spot Exchange Rate: It is the rate at which currency of two countries are exchange in the current/present market.

Forward Exchange Rate: It is the rate in present at which currencies of two countries will be exchanged on a future date. It means that the exchange rate is determined today but exchange will take place on a future date.

Forward Rate Differential: It is defined by : [(F-S)/S]*360/n

Where F: is forward rate

S : spot exchange rate

n : expiry of future contract (in years/months/days)

Interest Rate differential: It can be defined by : (1+r(a))/(1+r(b))-1

Where r(a) is nominal interest rate in country a (domestic country)

and r(b) is the nominal interest rate in country b (foreign country)

Interest Rate Parity Theory: According to this theory, forward rate differential should be equal to interest rate differential. If it is not equal then covered interest arbitrage will take place i.e. trader will take benefit of differences of nominal interest rates between two countries and they will borrow from low interest country and lend/invest in the country with higher nominal interest rate. This will again bring the market in equilibrium and forward rate differential will become equal to interest rate differential.