You can buy or sell the yen spot at ¥102 to the dollar. You can buy or sell the yen one-year forward at ¥104 to the dollar. If U.S. annual interest rates are 4 percent,what must be the approximate one-year Japanese interest rate if interest rate parity holds?

Question

Quizplus · Accepted Answer

Interest rate parity (IRP) ensures that the return on a domestic asset is equal to the return on a foreign asset, adjusted for exchange rates. The formula for IRP is: (1 + i_d) = (S/F) * (1 + i_f), where i_d is the domestic interest rate, i_f is the foreign interest rate, S is the spot exchange rate, and F is the forward exchange rate. Here, i_d is 4%, S is ¥102/$, and F is ¥104/$. Rearranging the formula to solve for i_f gives i_f = [(S/F) * (1 + i_d)] - 1. Substituting the given values: i_f = [(102/104) * (1 + 0.04)] - 1 ≈ 0.0604 or 6.04%.

You Can Buy or Sell the Yen Spot at ¥102