Question

1) What is the interest parity condition? Explain. Be sure to include an example. (4 points) Interest muity condition is

Answer 1

Interest parity condition can be defined as a condition when expected returns on deposit of any 2 currency are equal and the both currency are converted into the same currency.

The foreign exchange market is in equilibrium when deposit of all currency offers the same expected rate of return.

R$=R euro+ (Ee $/ euro – E $/ euro)/ E$/euro.

If R euro is Interest rate in UK=5%

E e $/euro is expected exchange rate =0.90

E $/euro is actual exchange rate=0.85

Then interest rate in USA will be

R$=R euro+ (Ee $/ euro – E $/ euro)/ E$/euro.

=5+(0.90-0.85)/0.85

=5+0.0588

=5.0588%