Explanation:
In the cost of carry framework, holding the underlying can generate a benefit analogous to income. For a foreign currency, that benefit is the foreign interest rate earned on the foreign currency balance.
This is most similar to the dividend yield on an investment asset, because both reduce the net cost of carrying the asset forward.
Therefore, the foreign risk-free interest rate is analogous to the dividend yield of the underlying asset.
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Question-166.4. Interest rate parity (IRP) can be viewed as an application of the cost of carry (COC) model where the underlying investment commodity is the foreign currency and the foreign risk-free interest rate is analogous to which COC factor? (Best answer)
A
Storage cost
B
Dividend yield of the underlying asset
C
Convenience yield of the underlying asset
D
The spot price