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P1.T3.503. Interest rate parity (Saunders)

Nicole Seaman

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Learning objectives: Describe how a non-arbitrage assumption in the foreign exchange markets leads to the interest rate parity theorem, and use this theorem to calculate forward foreign exchange rates. Explain why diversification in multicurrency asset-liability positions could reduce portfolio risk. Describe the relationship between nominal and real interest rates.


503.1. A bank purchases a six-month, $1.0 million Eurodollar deposit at an interest rate of 2.5% per annum with semiannual compounding. It invests the funds in a six-month Swedish krone AA-rated bond paying 3.5% per annum. The current SEKUSD spot rate is $0.1140 per 1.0 krona (kr, https://en.wikipedia.org/wiki/Swedish_krona). The six-month forward rate on the Swedish krone is being quoted at SEKUSD $0.1210. If the bank covers its foreign exchange exposure using the FX forward market, which is nearest to the net spread earned on this investment per annum with semiannual compounding? (note: variation on Saunders' Question #22)

a. 2.38%
b. 4.75%
c. 7.93%
d. 13.50%

503.2. Assume that interest rates are 1.0% per annum with annual compounding in the United States and 9.0% in Brazil. An bank can borrow (by issuing CDs) or lend (by purchasing CDs) at these rates. The USDBRL spot exchange rate is R$ 3.500 per 1.0 US dollar. Which is nearest to the forward exchange rate implied by the interest rate parity theorem (quoted USDBRL with Brazilan real as the quote currency)?

a. R$ 2.85
b. R$ 3.54
c. R$ 3.78
d. R$ 4.07

503.3. Suppose the current EURUSD spot exchange rate is $1.1300. Eurozone inflation is 5.0% while U.S. inflation is only 2.0%. According to purchasing power parity (PPP), which is nearest to the new EURUSD spot exchange rate that should result from the difference in inflation rates?

a. $1.0961
b. $1.1128
c. $1.1300
d. $1.1403

Answers here: