Suppose India is home country and USA is foreign country. Interest rate in India is 3%, that in US is…
Indian rates are 3% a year, about 0.75% for three months, while US rates of 1% give about 0.25%. The dollar's forward premium, (81 − 80)/80 = 1.25% for three months, exceeds…
Choose your answer
(A) Indian Rupee will depreciate in spot market
(B) Indian Rupee will depreciate in forward market
(C) Interest rate will decline in India
(D) Interest rate will decline in US
Answer and explanation
Correct answer C
Indian rates are 3% a year, about 0.75% for three months, while US rates of 1% give about 0.25%. The dollar's forward premium, (81 − 80)/80 = 1.25% for three months, exceeds this interest gap, so investors borrow in India, buy dollars spot, invest in the US and sell the dollars forward. Buying dollars spot makes the rupee depreciate in the spot market, and the inflow of funds lowers US interest rates. Meanwhile, selling dollars forward strengthens the rupee in the forward market, and borrowing in India pushes Indian rates up, so B and C are wrong.
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UGC NET Economics