If interest rate parity holds between the US and a foreign country, transaction

Question

If interest rate parity holds between the US and a foreign country, transaction costs are zero, and the forward rate is an unbiased predictor of the future spot rate, then the effective financing rate for a US company that borrows the foreign currency on a covered basis would be:

                  A) Equal to the US interest rate

                  B) Less than the US interest rate

                  C) More than the US interest rate

D) Less than the US interest rate and if the forward rate exhibited a discount, and more than the US interest rate if it exhibited a premium

E) Equal to the foreign interest rate

Explanation / Answer

E is correct.

As the US company borrows in foreign currency, the interest rate applicable would be foreign interest rate. As it borrows on a covered basis, the foreign currency risk is hedged and the interest rate would be equal to that of foreign country.

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