Suppose that the one-year interest rate is 4.0 percent in the Italy, the spot exchange rate is $1.60/€, and the one-year forward exchange rate is $1.58/€. What must one-year interest rate be in the United States?

Question

Quizplus · Accepted Answer

To solve the problem, we can use the interest rate parity formula:
(1 + i€) = (1 + i$) x (F/S)
where i€ is the interest rate in Europe, i$ is the interest rate in the US, F is the forward exchange rate, and S is the spot exchange rate. Plugging in the given numbers, we get:
(1+0.04) = (1+i$) x (1.58/1.60)
1.04 = (1+i$) x 0.9875
1+i$ = 1.04/0.9875
i$ = 0.027 or 2.7%
Therefore, the answer is B.

Suppose That the One-Year Interest Rate Is 4