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Foreign Exchange Rate & interest rate parity

Should Interest Rate Parity Prevent MNCs from Investing in Foreign Currencies?

Point
Yes. Currencies with high interest rates have large forward discounts according to interest rate parity. To the extent that the forward rate is a reasonable forecast of the future spot rate, investing in a foreign country is not feasible.

Counter-Point
No. Even if interest rate parity holds, MNCs should still consider investing in a foreign currency. The key is their expectations of the future spot rate. If their expectations of the future spot rate are higher than the forward rate, the MNCs would benefit from investing in a foreign currency.

Who Is Correct?

Solution Preview

The point is correct. Since the forward rate is a reasonable forecast of the future spot rate, investing in a foreign country is not feasible. Even if an MNC has an expectation of a higher future spot rate than the forward rate, the MNC should not invest in foreign currency. The risk of adverse movement of currency rates is high and can lead to losses for the MNC. There are several factors that may lead to adverse foreign currency investment. The foreign currency belongs to a foreign country and the national debt levels and trade levels may change dramatically. Also the interest rates and investor's expectation relating to interest rates may change unexpectedly. The foreign exchange rate may be adversely affected by the investing activity of mutual ...

Solution Summary

Interest rate parity is explained in a structured manner in this response. The answer includes references used.

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