Assume that interest rate parity exists. The annualized interest rate is present
ID: 2717031 • Letter: A
Question
Assume that interest rate parity exists. The annualized interest rate is presently 4% in the U.S. for any term to maturity, and is 8% in Sri Lanka for any term to maturity. Detroit Airplane Parts (U.S. firm) has an agreement in which it will develop and export software to Sri Lanka’s government two years from now, and will receive 22 million Sri Lankan Rupees in two years. The spot rate of the rupee is $.0079. Detroit Airplane Parts uses a 2-year forward contract to hedge its receivables in two years. How many dollars will Detroit Airplane Parts receive in two years? Show your work.
Explanation / Answer
Country TwoYear Compounded Return
U.S. (1.04)2 – 1 = 8.16%
Sri Lanka (1.08)2 – 1 = 16.64%
FR premium = (1.0816/1.1664) – 1 = -7.27%.
FR = (1 - .0727) x $.0079 = $.007325
Number of dollars to be received = $.007325 x 22 Sri Lankan Rupees= $161,150.