Question
According to the Interest Rate Parity (IRP) theory, if
the 1-year risk-free interest rate in India is 10% and the 1-year risk-free interest rate in the USA is 4%, and the current Spot Rate is ₹83/USD, what should be the 1-year Forward Rate?Solution
The currency of the country with the higher interest rate (India) should trade at a forward discount, and the currency with the lower interest rate (USA) should trade at a forward premium. Forward rate = Spot x (1+Home interest rate / 1+ Foreign interest rate) = 83 x ((1+0.10) / (1 + 0.04) = 87.80 Since Forward rate > Spot rate, there is forward premium. The USD is at a premium of approximately 5.7% because the interest rate differential must be offset by the exchange rate change to prevent arbitrage.
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