Question

Assume that interest rate parity holds and will continue to hold in the future. At the beginning of the month, the spot rate of the British pound is $1.60 while the 1-year forward rate is $1.50. Assume that U.S. annual interest rate remains steady over the month. At the end of the month, the one-year forward rate of the British pound exhibits a discount of 1%. Explain how the British annual interest rate changed over the month, and whether it is higher, lower, or equal to the U.S. rate at the end of the month.

Answer 1

The British annual interest rate increased over the month.

Explanation:

The 1-year forward rate for the British pound exhibited a discount of 1% at the end of the month relative to the start of the month.

The following scenario would have happened-

The British annual interest rate was increasing over the course of the month. Having assumed that the U.S. annual interest rate remains steady over the month, we can say that the demand for British pound would have increased because of the increasing British annual interest rate.

As demand for the British pound increased, the spot exchange rate for buying pound increased. For interest rate parity to hold, in equilibrium, the forward exchange rate would have to fall to completely eliminate the attractiveness of the British investments.

Hence the 1-year forward rate has exhibited a discount over the month.

At the end of the month, the British annual interest rate is lower than the U.S. rate, as the 1-year forward rate is still more than $1.