Suppose the 360-day forward exchange rate is 1.657 dollars per British pound, and the current spot
rate is 1.625 dollars per British pound.
If the 360-day interest rate in the United States is 5% and the
360-day interest rate in Great Britain is 3%, is the market in equilibrium according to the interest
rate parity theory?
A) No, because the forward premium on the pound is 2% while the interest rate in the United
States is 67% higher than the interest rate in Great Britain.
B) No, because the higher interest rate in the United States (2%) implies that the forward
exchange rate should be 2% lower than the current spot rate.
C) Yes, because the forward premium on the pound (2%) is exactly offset by the lower interest
rate in Great Britain.
D) Cannot be determined without knowing the amount of money being exchanged.
C
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