Since interest rate parity hol

  1. Since interest rate parity holds, then MNCs should advise theirsubsidiaries against investing any excess cash in a foreigncountry. Is this statement correct? Explain your answer.

  1. In a developing country, would an increase in the interest ratealways be followed with an appreciation of the country’s currency?Explain your answer.  

  1. A U. S. firm plans to invest 75 percent of its excess cash in aone-year British pound (GBP) deposit and the remaining 25 percentin Indian rupees (INR). It is assumed that the spot rate changesfor GBP and INR are independent. The possible percentage changes inthe spot rate of the two currencies for the next year areforecasted as follows.


Possible % change in the spot rate














The annual interest rate on the GBP is3%, the annual interest rate on the INR is 4%, and the annualinterest rate in the U.S. is 6%. The

  1. Calculate the possible effective yields of the overallportfolio.

  1. Would you advise the U. S. company to invest its excess fundsabroad or at home? Justify your answer considering that the MNCcould place the excess funds in GBP deposit only, INR deposit only,in USD deposit only, and in the 75-25 portfolio of currency ascalculated earlier) .


a.The given statement is correct.

Interest rate parity (IRP) is a theory in which the interestrate differential between two countries is equal to thedifferential between the forward exchange rate and the spotexchange rate.

Interest rates between two countries always different so thatwecan get the arbitrage opportunity ny using interest rate parity.

b.The Formula For Interest Rate Parity (IRP) Is

F = S [ (1+iR) / (1+iF) ]

F = Forward rate

iR = Interest rate indomestic country

iF = Interest rate in foreighn country

S = Spot Rate

By observing above equation we can easily get the relationshipbetween Interest rate and forward currency rate ,Hence Interestrate increases Currency value also increses,Hence given statementalso correct.


i) we will do it with the example,If we have 100 $ ,

75% Invested in Pounds i.e $ 75   

25% Invested in rupees i.e,$ 25

For Pound change in currency

% Change(1) Probability(2) (1)*(2)
0.02 0.2 0.004
0.03 0.8 0.024
NetChange 0.028

For Rupee change in currency

% Change(1) Probability(2) (1)*(2)
0.04 0.7 0.028
0.05 0.3 0.015
NetChange 0.043
Change ofCurrency Net Change onCurrency
0.00028 0.99972
0.00043 0.99957
Currencytype Currency(1) InterestRate(2) (1)*(2) Currency ChangeEffect Return Fromcurrency
Pound 75 1.03 77.25 0.99972                 77.2284
Rupess 25 1.04 26 0.99957                 25.9888
Intial Amount 100
Net Return                   3.2172
Net yield in % 3.2172%

If the Company in US , It will get $ 6 ,but investing in othercountries it will get $ 3.2172,Hence company should invest

in US.

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