Answer to Question #150934 in Financial Math for KIM RAHEE

Question

c. What does the nominal interest rate parity state? Would the condition be violated if nominal interest rates in the domestic and foreign country were different on two securities that were identical in all aspects? A currency premium would lead to a modification of the nominal interest rate parity condition. Why?

Answer 1

The nominal interest rate of parity states that, at equilibrium, the forward rate of a foreign currency will not be equal (in %) from the present spot rate by a figure that will equate the interest rate differential (in%) between the home and foreign country.

The condition will not be violated if the nominal interest rates in the domestic and foreign countries  were different on two securities that were identical in all aspects because the basic premise of interest rate parity is that hedged returns from investing in different currencies should be the same, regardless of their interest rates.

A currency premium would lead to a modification of the nominal interest rate parity condition because Interest rate parity is the fundamental equation that regulates the connection between interest rates and currency exchange rates.