Assume that interest rate parity holds, and the euro's interest rate is 9 percent while the U.S. interest rate is 12 percent. Then the euro's interest rate increases to 11 percent while the U.S. interest rate remains the same. As a result of the increase in the interest rate on euros, the euro's forward ____ will ____ in order to maintain interest rate parity.
A) discount; increase
B) discount; decrease
C) premium; increase
D) premium; decrease

Question

​Assume that interest rate parity holds, and the euro's interest rate is 9 percent while the U.S. interest rate is 12 percent. Then the euro's interest rate increases to 11 percent while the U.S. interest rate remains the same. As a result of the increase in the interest rate on euros, the euro's forward ____ will ____ in order to maintain interest rate parity.
A) ​discount; increase
B) ​discount; decrease
C) ​premium; increase
D) ​premium; decrease

Quizplus · Accepted Answer

According to interest rate parity, the forward rate must adjust to reflect the difference in interest rates between two countries. As the euro's interest rates increase relative to the U.S. interest rates, demand for euros will increase which will drive up the value of the euro. This will result in a premium on the euro's forward rate, as investors will be willing to pay more for the forward contract in order to lock in the higher interest rate on euros. Therefore, the euro's forward premium will increase to maintain interest rate parity.

​Assume That Interest Rate Parity Holds, and the Euro's Interest

Assume That Interest Rate Parity Holds, and the Euro's Interest