Under equilibrium conditions, the differential between foreign and domestic interest rates must mirror the spread in ___________?
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Answer: B. forward and spot exchange rates
Explanation
Interest rate parity requires differentials to match forward and spot exchange rates. Arbitrage forces the relationship between interest rates and exchange rates to hold. The forward discount or premium directly reflects the nominal interest rate gap. Interest rate parity is a foundational concept in international finance today. The formula equates the ratio of spot and forward rates to interest differentials. Covered interest arbitrage prevents riskless profit opportunities in global markets.
Multinational corporations use this parity condition to hedge currency risks effectively. Investors evaluate foreign bonds using this mechanism to calculate expected returns. Central banks monitor these rate spreads when formulating domestic monetary policy. Domestic rates alone cannot capture international currency market price differentials. Spot rates without forward rates fail to capture expected future valuations. The forward rate itself needs comparison with the spot rate for parity.
- Subject
- Accounting and Finance
- Category
- Finance
- Topic
- —
- Difficulty
- medium
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