4. Interest rate parity

The rise of globalization is due to the many companies that have become multinational corporations for various reasonsfor example, to access better technology, to enter new markets, to obtain more raw materials, to find funding resources, to minimize production costs, or to diversify business risk. This multimarket presence exposes companies to different kinds of risk as wellfor example, political risk and exchange rate risk.

The relationship between interest rates and exchange rates can be represented through the concept of interest rate parity. Consider the following:

Suppose you observe the following spot and forward exchange rates between the U.S. dollar ($) and the Canadian dollar (C$):

	Spot Exchange Rate	One-Year Forward
		Exchange Rate
Canadian dollar (U.S. dollar/Canadian dollar)	0.8932	0.9133

The current one-year interest rate on U.S. Treasury securities is 7.35%. If interest rate parity holds, what is the expected yield on one-year Canadian securities of equal risk?

4.99%

3.99%

4.49%

5.49%

Interest rate parity recognizes that when you invest in a country other than your home country, two factors affect your investmentreturns on the investment itself and changes in the exchange rate. Which of the following would cause the overall return on your investment to be higher than the investments stated return?

(A) The currency in which the investment is denominated depreciates relative to your home currency.

(B) Your home currency appreciates relative to the currency in which the investment is denominated.

(C) The currency in which the investment is denominated appreciates relative to your home currency.