Assume that the U.S. interest rate is 11% while the interest rate on the euro is 7%. If euros are borrowed by a U.S. firm, they would have to ____ against the dollar by ____ in order to have the same effective financing rate from borrowing dollars.
A) depreciate; about 3.74%
B) appreciate; about 3.74%
C) appreciate; about 4.53%
D) depreciate; about 4.53%

Question

Quizplus · Accepted Answer

To have the same effective financing rate, the interest rate differential between the euro and the dollar needs to be offset by the exchange rate movement. The higher interest rate in the US suggests a higher demand for dollars, which, in turn, causes the value of the dollar to appreciate. Therefore, the euro needs to appreciate against the dollar to offset the interest rate differential. Using the interest rate parity formula, the expected exchange rate change is calculated as (1+ US interest rate)/(1+ euro interest rate) - 1, which equals 3.74%. So, the euro needs to appreciate by approximately 3.74% against the dollar. Therefore, the correct option is B.

Assume That the U