Suppose 90-day investments in Britain have a 6% annualized return and a 1.5% quarterly (90-day) return. In the U. S., 90-day investments of similar risk have a 4% annualized return and a 1% quarterly (90-day) return. In the 90-day forward market, 1 British pound equals $1.50. If interest rate parity holds, what is the spot exchange rate ($/£)?
a) $1.5074
b) $1.4019
c) $1.4924
d) $1.5376
e) $1.7185

$1.53776

Explanation:

Using the interest rate parity formula :

Forward currency exchange rate (F) = 1.50

SPOT rate (S) =?

Interest rate on domestic currency (Id) = 1%

Interest rate on foreign currency (If) = 1.5%

SPOT RATE(S) is given by;

S = F × (1 + If) ÷ (1 + Id)

S = 1.50 ×(1 + 0.015) ÷ (1 + 0.01)

S = (1.50 × 1.015) ÷1.01

S = 1.5225 × 1.01

S = $1.537725

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