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Exchange Rate Relationships and Heading Exchange Rate Risk

Exchange Rate Relationships. Define each of the following theories in a sentence or simple equation.
a. Interest rate parity theory.
b. Expectations theory of forward rates.
c. Law of one price.
d. International Fisher effect

Heading Exchange Rate Risk. An importer in the United States is due to take delivery of silk scarves
from Europe in 6 months. The price is fixed in euros. Which of the following transactions could
eliminate the importer's exchange risk?
a. Buy euros forward.
b. Sell euros forward.
c. Borrow euros, buy dollars at the spot exchange rate.
d. Sell euros at the spot exchange rate, lend dollars.


Solution Preview

a. Interest-rate parity theory
According to interest rate parity theory, the difference in interest rates must equal the difference between the future and current exchange rates.
F0=Forward Price (expressed as Pound per $)
E0=Current Rate
Risk free rate in foreign country = ruk
Risk free rate in domestic country = rus
F0 = E0*(1+r)/(1+rd)

b. Expectations ...

Solution Summary

Expectations theory of forward rates is examined.