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You have $100,000 to invest for the next year. The Euro is currently trading at 1.18USD/Euro. The 1 year forward rate on the Euro is 1.20 USD/Euro.

A one year bank CD in USD is paying 2%.
What would the one year Euro CD rate be if interest rate parity holds?
1) 3.7%
2) 1%
3) 0.3%
4) 0.1%

User Gokan
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1 Answer

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Final answer:

The correct Euro CD rate that would maintain interest rate parity, given a 2% USD CD rate and the given forward and spot exchange rates, would be approximately 1.7%, though this option is not provided in the question.

Step-by-step explanation:

The student has $100,000 to invest and is considering different investment options concerning the Euro and U.S. Dollar based on interest rate parity. The forward exchange rate for the Euro is 1.20 USD/Euro, compared to the current rate of 1.18 USD/Euro. A one year bank CD in USD is paying 2%. To maintain interest rate parity, the Euro CD must offset the forward premium or discount on the Euro against the USD as well as match the return of the USD investment.

Interest rate parity implies: (1 + rUSD) = (1 + rEuro) * (Forward rate / Spot rate).

Plugging in the given rates: (1 + 0.02) = (1 + rEuro) * (1.20 / 1.18) leads to solving for rEuro. Calculating this out gives rEuro = (1.02 / (1.20 / 1.18)) - 1, which is approximately 0.017 or 1.7%. This is not one of the provided options, implying a potential mistake in the setup or the given answer choices. However, the principle of interest rate parity is used to calculate comparable interest rates based on currency values.

User RJnr
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