Suppose that the one-year interest rate is 5.0 percent in the United States; the spot exchange rate is $1.20/€; and the one-year forward exchange rate is $1.16/€.What must the one-year interest rate be in the euro zone to avoid arbitrage?
A)5.0%
B)6.09%
C)8.62%
D)none of the options

Question

Quizplus · Accepted Answer

To avoid arbitrage, the interest rate parity condition should hold. That means the following equation must hold:

(1 + US interest rate) = (1 + euro interest rate) * (forward exchange rate / spot exchange rate)

Plugging in the given values:

(1 + 0.05) = (1 + euro interest rate) * (1.16/1.20)

Solving for the euro interest rate:

1.05 = (1 + euro interest rate) * 0.9667
1.05 / 0.9667 = (1 + euro interest rate)
euro interest rate = 1.0862 - 1 = 0.0862 = 8.62%

Therefore, the one-year interest rate in the euro zone must be 8.62% to avoid arbitrage. So, the correct answer is option C.

Suppose That the One-Year Interest Rate Is 5