Describe the interest rate parity theory, Financial Management


(a) Describe the Interest Rate Parity Theory.

(b) A company needs to pay in 3 months USD 1 million. The USD are already at disposal in the company, thus the company decides how to invest them in the given period. You have the following data:

$ 3-month deposit rate: 8% (annualised)
£ 3-month deposit rate: 10% (annualised)
Direct quotes: Spot rate: $1,80/£
3-month forward rate: $1,78/£

By giving detailed reasoning, answer the given questions:

(i) Where should the company invest in the USA or in UK?

(ii) Consider that the interest rates and the spot rate stay the same, what forward rate ensure that there is no arbitrage?

The price of the pound sterling in Paris is Euros 1.2724 and 2.0556 CHF in Zürich. In Frankfurt we can come across with the exchange rate Euro 0.6338/CHF.

(i) How is it possible for an arbitrageur from London to realize profits? Describe.

(ii) All else being equal, which rate in Paris would ensure the no arbitrage condition?

Posted Date: 11/17/2013 9:51:34 PM | Location : United States

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