Suppose that one-year Treasury bills yield 4 percent in the United States and 5 percent in Germany. Investors will be indifferent between them if they expect the dollar over the next year to
A) depreciate against the euro by approximately 1 percent.
B) appreciate against the euro by approximately 1 percent.
C) depreciate against the euro by exactly 20 percent.
D) appreciate against the euro by exactly 20 percent.

Question

Quizplus · Accepted Answer

The difference between the two interest rates (5% - 4% = 1%) is called the interest rate differential. Investors will be indifferent between the two currencies if they expect the exchange rate to move by exactly the same amount as the interest rate differential (in this case, the dollar is expected to appreciate against the euro by approximately 1%). This is because investors would earn the same return regardless of which currency they invest in, once the exchange rate changes are taken into account. Therefore, choice B is the correct answer.

Suppose That One-Year Treasury Bills Yield 4 Percent in the United