Question

Currently, interest rate is 2 percent per annum in the U.S. and 6 percent per annum in the euro zone, respectively. The spot exchange rate is $1.25 = €1.00, and the one-year forward exchange rate is $1.20 = €1.00. As informed traders recognize the deviation from IRP and start carrying out covered interest arbitrage transactions to earn a certain profit, how will IRP be restored as a result?

		A. Interest rate in the euro zone will rise; interest rate in the U.S. will fall; euro will appreciate in the spot market; euro will appreciate in the forward market
		B. Interest rate in the euro zone will fall; interest rate in the U.S. will rise; euro will depreciate in the spot market; euro will depreciate in the forward market
		C. Interest rate in the euro zone will rise; interest rate in the U.S. will fall; euro will depreciate in the spot market; euro will appreciate in the forward market
		D. Interest rate in the euro zone will fall; interest rate in the U.S. will rise; euro will appreciate in the spot market; euro will depreciate in the forward market

Answer 1

Fair forward rate as per IRP = Spot rate*(1+Interest rate US)/(1+Interest rate Eurozone)

= 1.25*(1+2%)/(1+6%)

= $1.2028/Euro

Hence, restoration of IRP will occur as follows:

C. Interest rate in the euro zone will rise; interest rate in the U.S. will fall; euro will depreciate in the spot market; euro will appreciate in the forward market

All of these will lead to restoration of IRP as increase in Interest rate in eurozone, falling of US interets rate, depreciation of euro in spot market will decrease forward rate as per IRP.

Appreciation of Euro in forward market to reach $1.2028 will restore IRP as well.