Suppose that the one-year forward price of euros in terms of dollars is equal to $1.113 per euro. Further, assume that the spot exchange rate is $1.05 per euro, and the interest rate on dollar deposits is 10 percent and on euro it is 4 percent. Under these assumptions
A) interest parity does not hold.
B) interest parity does hold.
C) it is hard to tell whether interest parity does or does not hold.
D) interest parity fluctuates.
E) Not enough information is given to answer the question.

Question

Quizplus · Accepted Answer

Interest parity holds if the forward exchange rate equals the expected future spot exchange rate based on interest rate differential. In this case, the forward rate is $1.113 per euro, and the expected future spot rate can be calculated as follows: 
Expected future spot rate = Spot rate x [(1 + domestic interest rate)/(1 + foreign interest rate)]^(time in years) 
= $1.05 x [(1 + 0.1)/(1 + 0.04)]^1 
= $1.1133 per euro 
Since the expected future spot rate equals the forward rate, interest parity holds.

Suppose That the One-Year Forward Price of Euros in Terms