You can buy or sell the £ spot at $1.98 to the pound. You can buy or sell the pound one-year forward at $2.01 to the pound. If U.S. annual interest rates are 5 percent,what must be the approximate one-year British interest rate if interest rate parity holds?

Question

Quizplus · Accepted Answer

Interest rate parity (IRP) formula is F/S = (1 + i_foreign)/(1 + i_domestic), where F is the forward exchange rate, S is the spot exchange rate, i_foreign is the foreign interest rate, and i_domestic is the domestic interest rate. Plugging in the given values: 2.01/1.98 = (1 + i_British)/(1 + 0.05). Solving for i_British gives approximately 3.45 percent.

You Can Buy or Sell the £ Spot at $1