If interest rate parity exists and transactions costs are zero, foreign financing with a simultaneous forward purchase of the currency borrowed will result in an effective financing rate that is:
A) less than the domestic interest rate.
B) greater than the domestic interest rate.
C) equal to the domestic interest rate.
D) greater than the domestic interest rate if the forward rate exhibits a premium and less than the domestic interest rate if the forward rate exhibits a discount.

Question

Quizplus · Accepted Answer

If interest rate parity exists and transactions costs are zero, it means that the cost of borrowing in a foreign currency, after accounting for the future exchange rate movements, will result in the same effective financing rate as borrowing in the domestic currency. Therefore, the effective financing rate will be equal to the domestic interest rate.

If Interest Rate Parity Exists and Transactions Costs Are Zero