Suppose that the expected dollar/euro exchange rate is $1.10 per euro. If the dollar interest rate is 7 percent and the euro interest rate is 2 percent, and the current dollar/euro exchange rate is $0.99 per euro, does the interest parity hold?
Select one:
a. Yes.
b. No.
Given,
Current exchange rate, SR = $0.99/euro
Expected rate, FR = $1.10/euro
Dollar interest rate, Idollar =7%
Euro interest rate, Ieuro = 2%
As per interest rate parity,
FR/SR = (1+Idollar)/(1+Ieuro)
FR = SR(1+Idollar)/(1+Ieuro)
By substituting the values in formula we get,
FR = 0.99(1+0.07)/(1+0.02) = 0.99(1.07/1.02) = $1.04/euro
The expected forward rate and forward rate calculated as per interest rate parity is not the same.
In this case, the interest rate parity does not holds.
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