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?

Question

Quizplus · Accepted Answer

From the interest rate parity formula it follows that
e? = (ft)(1 + rf)/(1 + rh)= (1.65 dollars/pound)(1.015)/(1.01)= 1.6582 dollars/pound.Another way to think of this is $1 invested today in the United States yields $1.01 90 days from now.Alternatively, investors could put their money in British securities.In this case, the investor would exchange today $1 for (1/1.6582)or 0.6031 pounds in the spot marketrue.This money could be invested in Britain and after 90 days this investment would be worth 0.6031(1.015)= 0.6121 pounds.Given the forward exchange rate, 0.6121 pounds is worth $1.01 90 days from now (0.6121 ×1.65 = $1.01).

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