5. 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.

Several factors affect the exchange rate of a currency with another currency. Which of the following statements are true about the factors that have an impact on exchange rates? Check all that apply.

X If the demand for a currency increases, the currencys value will decrease relative to other currencies.

X If a government intends to let its currencys value fall relative to other currencies, it will sell its currency from reserves in the market.

X When interest rates decrease in a country, its currencys value tends to decrease because domestic investors convert their home currency into other currencies to invest in these higher yielding securities.

X If a country experiences greater inflation than its trading partners, the value of its currency decreases over time relative to the value of its partners currencies.

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

An American investor is considering investing $1,000 in default-free 90-day Japanese bonds that promise a 2% annual nominal return.

	The spot exchange rate is 103.40 per dollar.
	The 90-day forward exchange rate is 102.29 per dollar.

The investors annualized return on these bondsif he or she can lock in the dollar return by selling the foreign currency in the forward marketwill be ................... .

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 lower than the investments stated return?

X Your home currency appreciates relative to the currency in which the investment is denominated.

X Your home currency depreciates relative to the currency in which the investment is denominated.

X The currency in which the investment is denominated appreciates relative to your home currency.