Business Degree Certification Practice Test

If the spread between spot and forward exchange rates equals the interest rate difference between two countries, what is this known as?

1. Purchasing-power equality

2. Commodity arbitrage

3. Currency hedging

4. Interest-rate parity

The correct answer is: Interest-rate parity

The concept of interest-rate parity is key to understanding the relationship between spot and forward exchange rates and the interest rates of two countries. When the spread between spot and forward exchange rates equals the interest rate difference between these countries, it indicates that investors are indifferent between holding assets in one country versus another after accounting for the expected changes in the currency's value due to interest rates. In practical terms, this means that if one country offers higher interest rates compared to another, the forward exchange rate will be adjusted so that holding currency in the higher interest rate country does not give arbitrage opportunities. Therefore, forward rates and expected future spot rates adjust to reflect differences in interest rates, ensuring there are no gains to be made from exploiting these differences. This balance is what defines interest-rate parity. The other options represent different financial concepts that do not specifically relate to the relationship between spot and forward exchange rates in conjunction with interest rates. Purchasing-power equality pertains to the notion that exchange rates should adjust to equalize the prices of identical goods in different countries. Commodity arbitrage deals with price discrepancies in physical commodities, while currency hedging is a risk management strategy used to offset potential losses in foreign exchange by using financial instruments or market strategies. These concepts are distinct from the