1. the domestic interest rate will equal the foreign interest rate plus a foreign exchange risk premium.
2. the forward discount on the domestic currency will equal the expected rate of depreciation of that currency in terms of foreign currency if there is no foreign exchange risk.
3. the domestic interest rate will equal the foreign interest rate plus the expected rate of depreciation of the domestic currency if there is no foreign exchange risk.
4. both options 2 and 3 are true.
Choose the correct option.
Option 2 is the correct one. The forward discount on the domestic currency equals the expected rate of depreciation of that currency plus a premium to cover foreign exchange risk. Option 3 is false because, even if the question were to state that interest parity held, the existence of country-specific or political risk is not ruled out. Hence, the difference between the domestic and foreign interest rates will not necessarily equal the forward discount on the domestic currency, even though the latter will equal the expected rate of depreciation of the domestic currency if there is no foreign exchange risk.
Option 1 would hold only if the expected rate of depreciation of the domestic currency is zero and if interest parity also holds with no premium for country-specific risk. Consider the following equation:
If the expected rate of depreciation of the domestic currency, Eπ , and the country-specific risk premium, ρd , are both zero,
as option 1 states.