1. the domestic interest rate will equal the foreign interest rate plus a country-specific risk premium plus the expected rate of depreciation of the domestic currency.
2. the domestic interest rate will equal the foreign interest interest rate plus the expected rate of depreciation of the domestic currency if there is no risk.
3. the domestic interest rate will equal the foreign interest rate plus a foreign exchange risk premium plus the expected rate of depreciation of the domestic currency.
4. none of the above.
Choose the correct option.
Option 4 is the correct one. The interest parity condition implies that the domestic interest rate will equal the foreign interest rate plus the forward discount on domestic currency plus a premium for country-specific risk. The efficient markets condition must also hold for the forward discount to equal the expected rate of depreciation of the domestic currency plus the premium for foreign exchange risk. In all choices but 4, both the interest parity and efficient market conditions are required.
For option 1 to be true, the forward discount on the domestic currency will have to equal the expected rate of depreciation of the domestic currency, which will happen only if the efficient markets condition holds and the foreign exchange risk premium is zero.
Option 3 would be true if the efficient markets condition also holds and the country-specific risk premium happens to be zero.
It is true that the domestic interest rate will equal to the foreign interest rate plus a risk premium plus the expected rate of depreciation of the domestic currency, as suggested by option 2, but this is the result of efficient markets and interest parity, not interest parity alone.