Question

5. Interest rate parity Aa Aa E 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. Several factors affect the exchange rate of a currency with another currency. Which of the following statements are true about the factors that have an impact on exchange rates? Check all that apply. If the demand for a currency increases, the currency's value will decrease relative to other currencies. If a country experiences greater inflation than its trading partners, the value of its currency decreases over time relative to the value of its partners' currencies. If a government intends to let its currency's value fall relative to other currencies, it will sell its currency from reserves in the market. When interest rates decrease in a country, its currency's value tends to decrease because domestic investors convert their home currency into other currencies to invest in these higher yielding securities. 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 0.8932 One-Year Forward Exchange Rate 0.9133 Canadian dollar (U.S. dollar/Canadian dollar) The current one-year interest rate on U.S. Treasury securities is 8.03%. If interest rate parity holds, what is the expected yield on one-year Canadian securities of equal risk? 6.78% O 6.22% O 5.37% 5.65%

Answer 1

As per interest rate parity,

F_f/d = S_f/d *((1+i_f)/(1+i_d))

Where, F_f/d is forward exchange rate (Foreign to domestic)

S_f/d is spot exchange rate

i_f is foreign risk free rate

i_d is domestic risk free rate

Using the information given above,

0.9133 = 0.8932*((1+0.0803)/(1+i_CAD))

i_CAD = 0.0565 or 5.65%

Therefore, yield on one year Canadian securities of equal risk = 5.65%

Interest rate parity theory, as can be understood from the equation described above, implies that an investment in one's home country should have the same return as a similar investment in a foreign country.