Explanation

According to the Interest Rate Parity (IRP) theorem, the forward exchange rate can be calculated using the formula:

$$F = S \times \frac{(1 + r_d)}{(1 + r_f)}$$

Where:

• $F$ = Forward exchange rate (USD/EUR)
• $S$ = Spot exchange rate = 1.25 USD/EUR
• $r_d$ = Domestic interest rate = 4% (USD rate)
• $r_f$ = Foreign interest rate = 7% (EUR rate)

Calculation:

$$F = 1.25 \times \frac{(1 + 0.04)}{(1 + 0.07)}$$ $$F = 1.25 \times \frac{1.04}{1.07}$$ $$F = 1.25 \times 0.97196$$ $$F = 1.21495 \approx 1.22$$

Why this makes sense:

• The EUR has a higher interest rate (7%) than USD (4%)
• According to IRP, the currency with higher interest rate should depreciate in the forward market
• Therefore, the forward rate (1.22 USD/EUR) is lower than the spot rate (1.25 USD/EUR)
• This creates an arbitrage-free condition where investors cannot profit from interest rate differentials alone

The correct answer is C. 1.22