Practice Quiz 7 — Interest Rate Parity & Forwards

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The spot rate is S = $/€ = 1.10 (it costs $1.10 to buy one Euro). The US interest rate is 5% and the Eurozone interest rate is 3%.

(a) Using covered interest rate parity, compute the 1-year forward rate F = $/€.

(b) Is the euro trading at a forward premium or forward discount relative to the dollar? In one sentence, explain why the country with the lower interest rate sees its currency at a forward premium.

(c) Using uncovered interest rate parity, what does the market expect S = $/€ to be in one year? A US investor is considering investing in 1-year Eurozone government bonds instead of US Treasuries. If UIRP holds, what excess return does the investor earn from this strategy? Explain in one sentence why this makes sense.