Question

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

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

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

Currency	Possible % change in the spot rate	Probability
GBP	0.02	0.2
GBP	0.03	0.8
INR	0.04	0.7
INR	0.05	0.3

The annual interest rate on the GBP is 3%, the annual interest rate on the INR is 4%, and the annual interest rate in the U.S. is 6%. The

1. Calculate the possible effective yields of the overall portfolio.

2. Would you advise the U. S. company to invest its excess funds abroad or at home? Justify your answer considering that the MNC could place the excess funds in GBP deposit only, INR deposit only, in USD deposit only, and in the 75-25 portfolio of currency as calculated earlier) .

Answer 1

a.The given statement is correct.

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

Interest rates between two countries always different so that wecan 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 relationship between Interest rate and forward currency rate ,Hence Interest rate increases Currency value also increses,Hence given statement also correct.

c.

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
	Net Change	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
	Net Change	0.043

Change of Currency	Net Change on Currency
0.00028	0.99972
0.00043	0.99957

Currency type	Currency(1)	Interest Rate(2)	(1)*(2)	Currency Change Effect	Return From currency
Pound	75	1.03	77.25	0.99972	77.2284
Rupess	25	1.04	26	0.99957	25.9888
					103.2172
Intial Amount	100
Net Return	3.2172
Net yield in %	3.2172%

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

in US.