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Interest rates are 8% in the U.S. Interest rates are 5% in Europe. You observe me...

  1. Interest rates are 8% in the U.S. Interest rates are 5% in Europe. You observe me investing in Europe at 5%. What can you infer about what I am expecting the € to do over this next year?
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  • As per the Interest Rate Parity Theory, the Interest rate differential between the two country's interest rates is always equal to the Currency Spot and Forward Rate differential. In other words the Country that has lower Interest Rate will be Selling at Premium in the Forward Market so the there does not exist any arbitrage possibility.
  • Now, in the given question since we are Investing in Europe that has lower Interest Rate hence we are Expecting Euro will be Selling at Premium in the Forward Market over the period of an year.
  • the reason is the Interest Rate Parity Theorm which defines the realationship between Interest Rates of two countries and the Spot and Forward Rate between such two country's exchange rates.
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