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Risk ManagementSection BRisk ManagementInterest Rate ParityForeign Exchange

ACCA · Question 30 · Risk Management

Section B - Case 3: LithiumX

Scenario: LithiumX is a cross-border mining company based in the US. It expects to receive €2,000,000 in exactly 3 months from a European client.
Spot exchange rate: €1.1500 - €1.1550 / $1
3-month forward rate: €1.1600 - €1.1640 / $1
US interest rates: 4% borrow, 2% deposit (annual)
Euro interest rates: 5% borrow, 3% deposit (annual)

Question: According to Interest Rate Parity (IRP), why is the 3-month forward rate higher (more Euros per Dollar) than the spot rate?

Answer options:

A.

Because US inflation is higher than Eurozone inflation.

B.

Because Euro interest rates are higher than US interest rates.

C.

Because US interest rates are higher than Euro interest rates.

D.

Because the market expects the Euro to appreciate against the Dollar.

How to approach this question

Recall the Interest Rate Parity theory: The forward rate is determined by the spot rate and the interest rate differential. The currency with the higher interest rate will trade at a forward discount (it will be worth less in the future).

Full Answer

B.Because Euro interest rates are higher than US interest rates.✓ Correct
Interest Rate Parity (IRP) ensures that investors cannot make riskless arbitrage profits by borrowing in a low-interest currency and depositing in a high-interest currency while hedging with a forward contract. To prevent this, the currency with the higher interest rate (Euro) must trade at a forward discount. A forward discount means the Euro is expected to weaken, so it takes more Euros to buy 1 US Dollar in the forward market (1.1640) than in the spot market (1.1550).

Common mistakes

Confusing IRP with PPP (inflation), or misinterpreting the exchange rate quote (thinking more Euros per Dollar means the Euro is stronger).
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