Question

5. Interest rate parity Aa Aa 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 increase relative to other currencies. If a government intends to prevent its currency's value from falling relative to other currencies, it will purchase its currency from sellers in the market. An increase in inflation tends to increase the currency's value with respect to other currencies with lower inflation When a government limits imports and restricts foreign exchange transactions, its currency's value tends to increase relative to other currencies The relationship between interest rates and exchange rates can be represented through the concept of interest rate parity. Consider the following: An American investor is considering investing $1,000 in default-free 90-day Japanese bonds that promise a 4% annual nominal return The spot exchange rate is ¥103.40 per dollar The 90-day forward exchange rate is ¥102.29 per dollar. The investor's annualized return on these bonds-if he or she can lock in the dollar return by selling the foreign currency in the forward market-will be Which of the following statements is implied by interest rate parity theory? An investment in one's home country should have the same return as a similar investment in a foreign country. Interest rates in all countries should be the same. A product bought in one country should have the same price in other countries, adjusted for exchange rate. Interest rates in all countries with the same political risk should be the same.

Answer 1

The exchange rate is determined by the market forces of demand and supply

Hence, the correct statements are:

First, second and last

If demand increases, value increases

If government wants to prevent value, should purchase

Limiting import will increase value as value will be restricted

Increase in inflation will reduce value

Convert into yen 1,000*103.40 = Yen 103,400

Return after 4% = 103,400(1+4%) = 107,536

Convert at forward rate = 107,536/102.29 = $1,051.29

Annualised Return = [(1,051.29 – 1000)/1000]*360/90

= 20.52%

A is correct

An investment in one’s home country should have the same return as a similar investment in a foreign country.