Assume that the one-year interest rate is 3% p.a. in the UK and 2% p.a. in the Euro area. Also, assume that the current spot exchange rate of one pound to the euro is €1.1500/£ and that the corresponding one-year forward exchange rate is €1.1400/£. i) Use calculations to show whether the Interest Rate Parity (IRP) theory holds. ii) A UK investor has £200,000 to invest for one year either in the Euro area or the UK. Using the above information, determine which investment will generate a higher return. iii) Explain whether your results in i) and ii) above provide support to, or contradict, the covered interest rate parity (CIRP) condition.

Assume that the one-year interest rate is 3% p.a. in the UK and 2% p.a. in the Euro area. Also, assume that the current spot exchange rate of one pound to the euro is €1.1500/£ and that the corresponding one-year forward exchange rate is €1.1400/£. i) Use calculations to show whether the Interest Rate Parity (IRP) theory holds. ii) A UK investor has £200,000 to invest for one year either in the Euro area or the UK. Using the above information, determine which investment will generate a higher return. iii) Explain whether your results in i) and ii) above provide support to, or contradict, the covered interest rate parity (CIRP) condition.

International Financial Management

14th Edition

ISBN:9780357130698

Author:Madura

Publisher:Madura

Chapter4: Exchange Rate Determination

Section: Chapter Questions

Problem 23QA

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b) Assume that the one-year interest rate is 3% (per annum) in the UK and 2% (per annum) in the Euro area. Also, assume that the current spot exchange rate of one pound to the euro is €1.1500/£ and that the corresponding one-year forward rate is €1.1400/£. i) Provide calculations to show whether the Interest Rate Parity (IRP) theory holds. ii) A UK-based investor has £200,000 to invest for a year either in the Euro area or the UK. Using the above information, determine which investment will generate a higher return for them. iii) Discuss the extent to which your results in i) and ii) above provide support to the Covered Interest Rate Parity (CIRP) condition.
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