Question

Suppose that the expected dollar/euro exchange rate is $1.10 per euro. If the dollar interest rate...

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.

Homework Answers

Answer #1

Given,

Current exchange rate, SR = $0.99/euro

Expected rate, FR = $1.10/euro

Dollar interest rate, I​​​​​​dollar =7%

Euro interest rate, I​​​​​​euro = 2%

As per interest rate parity,

FR/SR = (1+I​​​​​dollar)/(1+I​​​euro)

FR = SR(1+I​​​​​dollar)/(1+I​​​​euro)

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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