Assume that the interest parity condition holds, the future expected exchange rate is constant, the current nominal exchange rate is 2.2, the one- year foreign interest rate is 7% and the one- year domestic interest rate is 4%. One could conclude that:
A) financial market participants expect that the exchange rate will increase by 4% over the coming year.
B) financial market participants expect that the exchange rate will increase by 3% over the coming year.
C) financial market participants expect that the exchange rate will decrease by 3% over the coming year.
D) financial market participants expect that the exchange rate will decrease by 4% over the coming year.
E) financial market participants expect the exchange rate to remain unchanged over the coming year.

Question

Quizplus · Accepted Answer

According to interest parity condition, the difference between two countries' interest rates equals the expected change in exchange rates. Therefore, the expected increase in exchange rate can be calculated as (7%-4%) = 3%. So, financial market participants expect that the exchange rate will increase by 3% over the coming year.

Assume That the Interest Parity Condition Holds, the Future Expected