Suppose 90-day investments in Britain have a 6% annualized return and a 1.5% quarterly (90-day) return.In the U.S., 90-day investments of similar risk have a 4% annualized return and a 1% quarterly (90-day) return.In the 90-day forward market, 1 British pound equals $1.65.If interest rate parity holds, what is the spot exchange rate?
A) 1 pound = $1.8000
B) 1 pound = $1.6582
C) 1 pound = $1.0000
D) 1 pound = $0.8500
E) 1 pound = $0.6031

Question

Quizplus · Accepted Answer

According to interest rate parity, the return on a foreign investment should equal the return on a domestic investment after adjusting for the exchange rate. 
Therefore, 1 pound invested in Britain would yield:
(1 + 0.06/4) * (1 + 0.06/4) * (1 + 0.06/4) = 1.01515 pounds
And investing 1 pound in the US would yield:
(1 + 0.04/4) * (1 + 0.04/4) * (1 + 0.04/4) = 1.01005 pounds
So the expected change in the exchange rate would have to be:
1.01005 / 1.01515 = 0.9950
Therefore, the spot exchange rate would be:
1 / 1.65 * 0.9950 = 0.6030 or 1 pound = $1.6582 (rounded to four decimal places)

Suppose 90-Day Investments in Britain Have a 6% Annualized Return