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%, what must be the approximate one-year British interest rate if interest rate parity holds?

Question

Quizplus · Accepted Answer

Using interest rate parity, we can solve for the approximate one-year British interest rate as:

1 + iGBP = (1 + iUSD) x (F/S)

where iGBP is the unknown British interest rate, iUSD is the U.S. annual interest rate (5%), F is the one-year forward exchange rate ($2.01/£), and S is the current spot exchange rate ($1.98/£).

Plugging in the values, we get:

1 + iGBP = (1 + 0.05) x (2.01/1.98)
1 + iGBP = 1.050505

Solving for iGBP, we get:

iGBP = 0.050505 = 5.05%

Therefore, the approximate one-year British interest rate is 5.05%. None of the answer choices match exactly, but the closest one is D, 3.48%.

You Can Buy or Sell the £ Spot at $1