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Suppose the one-year risk-free interest rate on the British pound is higher than its counterpart on...

Suppose the one-year risk-free interest rate on the British pound is higher than its counterpart on the euro: i£ > i€. In this situation, if the interest parity condition holds,

  1. the pound would be expected to appreciate against the euro between now and a year from now.
  2. the pound would be expected to depreciate against the euro between now and a year from now.
  3. the pound-euro exchange rate would be expected to remain constant.
  4. the pound may be expected to appreciate or depreciate against the euro, depending on other factors.
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Answer #1

According to tot he interest parity condition, if the risk-free interest rate in one country is higher than another country, then in order to ensure that an investor can do not have arbitrage opportunities, the currency in that country will depreciate to keep the real returns same.

Thus, the answer is (b) the pound would be expected to depreciate against the euro between now and a year from now.

All other options are incorrect as they do not follow from the interest parity condition of international finance.

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