Question

If interest rate parity holds, what would happen to the forward rates when the foreign currency money market offers a higher return than the domestic money market? What would happen if the adjustment does not take place? Explain your answer

Answer 1

If interest rate parity holds, then because foreign currency is offering a higher return, that currency would depreciate relative to the domestic curreny or the domestic currency will appreciate. Hence, if we are writing the exchange rate in the form of foreign per domestic currency, it would increase.

If the adjustment in the exchange rate does not take place, there will be an arbitrage opportunity for traders and they would continuously buy the forwards and sell the spot as they would know that the right rate should be higher than what it is now.