Answer to Question 1:

Suppose that the interest rate in Great Britain is 7 percent per year and there is a one-year forward premium on the New Zealand dollar of 3 percent. The interest rate in New Zealand will therefore be 4 percent per year.

True or False?


The correct answer is False. No mention is made of the risk of holding New Zealand as opposed to U.K. assets. It could be that there is a 3 percent risk premium on British assets. If there is no risk differential---that is, covered interest parity holds---then the interest rate in New Zealand will be 4 percent as the question states.

Recall that the domestic/foreign interest rate differential can be expressed as

     id - if = Ψ + ρd

where ρd is the difference in the risk on the two countries' assets. Letting New Zealand be the domestic economy, we can rearrange the above equation to yield

     inz - iuk = Ψ + ρd

If ρd is zero, then   inz = (- 3) + 7 = 4.   Otherwise,   inz = 4 + ρd , where  ρd can be positive or negative.

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