   Chapter 17, Problem 3P

Chapter
Section
Textbook Problem

INTEREST RATE PARITY Six-month T-bills have a nominal rate of 2%, while default-free Japanese bonds that mature in 6 months have a nominal rate of 1.25%. in the spot exchange market, 1 yen equals $0.0081. If interest rate parity holds, what is the 6-month forward exchange rate? Summary Introduction To determine: The 6-month forward exchange rate. Introduction: Interest Rate Parity: It refers to that theory which indicates the difference of interest rates provided by two different countries to be the same as the difference of forward exchange rate and spot exchange rate. Explanation Given information: The nominal rate of six-month t-bills is 2% or 0.02. The nominal rate of six-month bonds is 1.25% or 0.0125. On the basis of spot exchange rate, 1 yen is equal to$0.0081.

Equation of interest rate parity,

Forwad exchange rateSpot exchange rate=(1+rh)(1+rf)

Where,

• rh is interest rate of t-bill.
• rf is interest rate of bonds.

Substitute \$0.0081 for spot exchange rate, 0.01 for rh , 0.00625 for rf in the above formula.

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