Assume the annual British interest rate is above the annual U.S. interest rate. Also assume the pound's forward rate of $1.75 equals the pound's spot rate. Given this information, interest rate parity ____ exist, and the U.S. firm ____ lock in a lower financing cost by borrowing pounds for one year.
A) does; could
B) does; could not
C) does not; could not
D) does not; could

Question

Quizplus · Accepted Answer

The fact that the annual British interest rate is above the annual U.S. interest rate indicates that there is an interest rate differential between the two countries. However, since the pound's forward rate of $1.75 equals the pound's spot rate, there is no expected future change in the exchange rate. This means that interest rate parity does not exist, which rules out options A and D. Furthermore, since interest rate parity does not exist, there is no arbitrage opportunity for the U.S. firm to lock in a lower financing cost by borrowing pounds for one year, which rules out option B. Therefore, the correct answer is C.

Assume the Annual British Interest Rate Is Above the Annual