A financial analyst is examining the currency exchange rate dynamics between the United States dollar (USD) and the Euro (EUR). To aid this analysis, the following market data is available:

The current exchange rate stands at 1.13 USD for 1 EUR.

The annualized risk-free interest rate for USD over 1 year is 2.7%.

The annualized risk-free interest rate for EUR over 1 year is 1.7%.

Using the interest rate parity (IRP) theory, compute the forward exchange rate for 1 EUR in terms of USD, specifically for a 2-year period.

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Explanation:

The correct answer is D: 1.1523. According to the interest rate parity theory, the forward exchange rate (F) can be calculated using the formula: $F = S \times \left(\frac{1 + R_{USD}}{1 + R_{EUR}}\right)^T$ , where:

$S$ is the spot exchange rate (1.13 USD per EUR in this case),
$R_{USD}$ is the USD risk-free rate (2.7% per year),
$R_{EUR}$ is the EUR risk-free rate (1.7% per year),
$T$ is the time to delivery (2 years in this scenario).

Plugging the given values into the formula, we get: $F = 1.13 \times \left(\frac{1 + 0.027}{1 + 0.017}\right)^2 = 1.1523$

This calculation shows that the 2-year forward USD per EUR exchange rate, based on the current spot rate and the risk-free interest rates for both currencies, is 1.1523. The other options (A, B, and C) represent incorrect calculations or assumptions about the rates and time periods involved.

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