Assume that interest rate parity holds. U.S. interest rate is 13% and British interest rate is 10%. The forward rate on British pounds exhibits a ____ of ____ percent.
A) discount; 2.73
B) premium; 2.73
C) discount; 3.65
D) premium; 3.65

Question

Quizplus · Accepted Answer

According to interest rate parity, the forward rate on a currency should equal the currency's spot rate times the ratio of the two countries' interest rates. Using this formula, the forward rate on pounds would be:

Forward rate = Spot rate x (1 + British interest rate) / (1 + U.S. interest rate)
Forward rate = Spot rate x (1 + 0.10) / (1 + 0.13)
Forward rate = Spot rate x 0.9709

Since the U.S. interest rate is higher than the British interest rate, the forward rate is at a premium. Therefore, the answer is B.

To calculate the percentage of the premium, we can take the difference between the forward rate and the spot rate, divide it by the spot rate, and then multiply by 100.

Premium = (Forward rate - Spot rate) / Spot rate x 100%
Premium = (Spot rate x 0.9709 - Spot rate) / Spot rate x 100%
Premium = 0.9709 - 1 x 100%
Premium = -2.91%

Note that the premium is negative, indicating that the dollar is expected to appreciate against the pound. However, the question only asks for the absolute value of the premium, which is 2.91%, or approximately 2.73% when rounded to two decimal places.

Assume That Interest Rate Parity Holds