Question

Use the information below to answer the following questions.

	Currency per U.S. $
Australia dollar	1.2380
6-months forward	1.2353
Japan Yen	100.3600
6-months forward	100.0200
U.K. Pound	.6789
6-months forward	.6784

Suppose interest rate parity holds, and the current risk-free rate in the United States is 5 percent per six months. Use the approximate interest rate parity equation to answer the following questions.

Requirement 1:

What must the six-month risk-free rate be in Australia? (Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Risk-free rate

%

Requirement 2:

What must the six-month risk-free rate be in Japan? (Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Risk-free rate

%

Requirement 3:

What must the six-month risk-free rate be in Great Britain? (Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Risk-free rate

%

Answer 1

(1 + rh) = [E0/Et] x (1 + rf)

where * rh is interest in home country

• rf is interest in foreign country

• E0 is current spot exchange rate, measured as units of foreign currencies per unit of home currency

• Et is forward exchange in t periods.

1). For Australia, applying the interest parity condition, we have

(1 + 5%) = [1.2353/1.2380] x (1 + r_aus)

1.05 = 0.9978 x (1 + r_aus)

r_aus = [1.05/0.9978] - 1 = 1.0523 - 1 = 0.0523, or 5.23%

2. For Japan, applying the interest parity condition, we have

(1 + 5%) = [100.02/100.36] x (1 + r_jpn).

1.05 = 0.9966 x (1 + r_jpn)

r_jpn = [1.05/0.9966] - 1 = 1.0536 - 1 = 0.0536, or 5.36%

3. For the U.K., applying the interest parity condition, we have

(1 + 5%) = [0.6784/0.6789] x (1 + r_GBR).

1.05 = 0.9993 x (1 + r_jpnGBR)

r_GBR = [1.05/0.9993] - 1 = 1.0508 - 1 = 0.0508, or 5.08%