The figure given below depicts the foreign exchange market for British pounds traded for U.S. dollars.Figure 22.2

-Assume a one year U.S. bond pays 4.0% interest and a similar U.K. bond pays 5.2% interest. Which of the following changes will establish interest rate parity?
A)The British pound would be expected to appreciate by 1.2% against the U.S. dollar.
B)The U.S. dollar would be expected to depreciate by 1.2% against the British pound.
C)The British pound would be expected to depreciate by 1.2% against the U.S. dollar.
D)The British pound would be expected to appreciate by 9.2% against the U.S. dollar.
E)The U.S. dollar would be expected to appreciate by 9.2% against the British pound.

Question

The figure given below depicts the foreign exchange market for British pounds traded for U.S. dollars.Figure 22.2
 
-Assume a one year U.S. bond pays 4.0% interest and a similar U.K. bond pays 5.2% interest. Which of the following changes will establish interest rate parity?
A)The British pound would be expected to appreciate by 1.2% against the U.S. dollar. 
B)The U.S. dollar would be expected to depreciate by 1.2% against the British pound. 
C)The British pound would be expected to depreciate by 1.2% against the U.S. dollar. 
D)The British pound would be expected to appreciate by 9.2% against the U.S. dollar. 
E)The U.S. dollar would be expected to appreciate by 9.2% against the British pound.

Quizplus · Accepted Answer

Interest rate parity is achieved when the difference in interest rates between two countries is equal to the expected change in exchange rates between the countries' currencies. Since the U.K. bond pays a higher interest rate (5.2%) compared to the U.S. bond (4.0%), for interest rate parity to hold, the British pound would be expected to depreciate by the difference in interest rates (1.2%) against the U.S. dollar. This depreciation compensates for the higher interest rate in the U.K., equalizing the returns for investors regardless of which country's bond they hold.

The Figure Given Below Depicts the Foreign Exchange Market for British