ACCA Financial Management (F9) Certification Practice Exam

Which of the following denotes the base country's interest in the Interest Rate Parity Theory formula?

1. hc

2. hb

3. F0

4. S0

The correct answer is: hb

In the context of the Interest Rate Parity (IRP) Theory, the variable representing the base country's interest rate is crucial for understanding how interest rates and currency exchange rates interact. The base country is typically the one whose currency is being compared to another in the analysis. In the IRP formula, the base country's interest rate (denoted as hb in this context) is essential because it is used to establish a relationship between the interest rates of the base country and the foreign country, and how these rates affect the forward and spot exchange rates. This principle suggests that the difference in interest rates between two countries will be equal to the change in the exchange rates over the same period, ensuring that arbitrage opportunities do not exist in the foreign exchange market. Thus, using hb appropriately allows for accurate calculations of what the forward rate should be based on the interest rate differential, facilitating hedging strategies or investment decisions. Other variables like hc, F0, and S0 represent different aspects of the IRP framework, such as the interest rate of the foreign country, the forward exchange rate, and the spot exchange rate, respectively. However, hb specifically refers to the interest rate of the base country, making it the correct choice in identifying the base country's interest