If interest rate parity exists and transactions costs are zero, foreign financing with a simultaneous forward purchase of the currency borrowed will result in an effective financing rate that is:
A) less than the domestic interest rate.
B) greater than the domestic interest rate.
C) equal to the domestic interest rate.
D) greater than the domestic interest rate if the forward rate exhibits a premium and less than the domestic interest rate if the forward rate exhibits a discount.

Question

Quizplus · Accepted Answer

If interest rate parity holds and there are no transaction costs, the forward exchange rate will reflect the interest rate differential between the two currencies. Therefore, if a foreign currency can be borrowed at the same interest rate as the domestic currency with zero transaction costs, the forward exchange rate will be such that the effective financing rate will be equal to the domestic interest rate.

If Interest Rate Parity Exists and Transactions Costs Are Zero