Question

4. Interest rate parity

The rise of globalization is due to the many companies that have become multinational corporations for various reasons—for example, to access better technology, to enter new markets, to obtain more raw materials, to find funding resources, to minimize production costs, or to diversify business risk. This multimarket presence exposes companies to different kinds of risk as well—for example, political risk and exchange rate risk.

The relationship between interest rates and exchange rates can be represented through the concept of interest rate parity. Consider the following:

Suppose you observe the following spot and forward exchange rates between the U.S. dollar ($) and the Canadian dollar (C$):

	Spot Exchange Rate	One-Year Forward
		Exchange Rate
Canadian dollar (U.S. dollar/Canadian dollar)	0.8711	0.8903

The current one-year interest rate on U.S. Treasury securities is 7.77%. If interest rate parity holds, what is the expected yield on one-year Canadian securities of equal risk?

5.45%

4.63%

5.18%

4.91%

Which of the following statements is implied by interest rate parity theory?

If two countries have the same inflation rate, they should have the same interest rate, too.

An investment in one’s home country should have the same return as a similar investment in a foreign country.

Interest rates in all countries with the same political risk should be the same.

A product bought in one country should have the same price in other countries, adjusted for exchange rate.

Answer 1

Interest

Current USD/CAD (S)=.8711

1 Year forward USD/CAD=.8903

interest rate in US (iD) =7.77%

interest rate in Canada (iF)=?

Formula of interest rate parity:

F/S=(1+iD)/(1+iF)

.8903/.8711=1+.0777/1+iF

1+iF=(1.0777*.8711)/.8903

iF=.0545 or 5.45%

Interest rate parity theory implies that:

An investment in one’s home country should have the same return as a similar investment in a foreign country.

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