The spot exchange rate in New York is 1.600 dollars per British pound. The 360-day forward exchange rate is

1.680 dollars per pound.

The one-year interest rate in Great Britain is 2% while the one-year interest rate in the
United States is 4%.
a. If the interest rate in Great Britain remains at 2%, what should the interest rate be in the United States
according to the interest rate parity theory?
b. An American investor with $40,000 decides to take advantage of the differences in rates. Ignoring
transaction costs, how can the American investor exploit the disequilibrium? Compare the amount of money the
investor will have at the end of the year if he or she invests in one-year U.S. securities versus one-year British
securities.

a. 7%. The forward rate is a premium of 5% over the spot rate. The interest rate parity theory suggests that the
difference in interest rates should be of the same magnitude as the difference in exchange rates, but in the opposite
direction.
b. If the investor buys U.S. securities, he or she will have ($40,000 × 1.