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Suppose the 1-year risk-free rate of return in the U.S. is 4%, and the 1-year risk-free rate of return in Britain is 7%. The current exchange rate is 1 pound = U.S. $1.65. A 1-year future exchange rate of __________ for the pound would make a U.S. investor indifferent between investing in the U.S. security and investing in the British security.

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Kolawole845

Answer:

A future exchange rate =  $1.60

Explanation:

The interest rate parity theory sates that  the relationship between forward rate and the spot rate between two currencies can be linked to the respective interest rates of the the currencies.

Using this model, the relationship is stated below:

Fo = So  × (1+c)/(1+m)

Fo = Forward  rate

So= Spot rate

C- inflation rate in the US

m- Inflation rate in Britain

A future exchange rate = 1.65 ×  (1.04)/(1.07) = $1.60

Answer:

A future exchange rate =  $1.60