Question

Assume the spot rate for the British pound currently is $1.5701/£. Also assume the one-year forward rate is $1.5574/£. A risk-free asset in the U.S. is currently earning 3.2 percent interest rate. If interest rate parity holds, what rate can you earn on a one-year risk-free British security? A) 2.37 percent B) 4.57 percent C) 3.67 percent D) 4.04 percent E) 4.92 percent

Answer 1

Answer:

D) 4.04 percent

Explanation:

Spot rate is £1 = $1.5701

Forward exchange rate after 1 year is £1 = $1.5574

Risk free rate in US = 3.2 %

Forward rate = {Spot rate * (1 + risk free rate in US)} / (1 + risk free rate in UK)

1.5574 = {1.5701 * ( 1 + 0.032)} / (1 + risk free rate in UK)

(1 + risk free rate in UK) = (1.5701 * 1.032) / 1.5574

Risk free rate in UK = (1.62034 / 1.5574) - 1

Risk free rate in UK = 1.0404 - 1

Risk free rate in UK = 0.0404

Risk free rate in UK = 4.04%