Assume that interest rate parity exists, and there are zero transactions costs. If the forward rate consistently underestimates the future spot rate, then:
A) on average, the foreign effective financing rate is greater than the domestic interest rate.
B) on average, the foreign effective financing rate is less than the domestic rate.
C) the foreign effective financing rate exceeds the U.S. interest rate when its forward rate exhibits a discount and is less than the U.S. interest rate when its forward rate exhibits a premium.
D) the foreign effective financing rate is less than the U.S. interest rate when its forward rate exhibits a discount and exceeds the U.S. interest rate when its forward rate exhibits a discount.

Question

Quizplus · Accepted Answer

If the forward rate underestimates the future spot rate, it implies that the foreign currency is expected to appreciate. This means that borrowing in foreign currency would result in a higher effective financing rate compared to the domestic interest rate.

Assume That Interest Rate Parity Exists, and There Are Zero