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Consider two currencies, the VKN and the PKR. The PKR is trading at an annual premium of 2.3% relative to the VKN in the forward market. The 1-year risk-free PKR rate is 3.0%. If no arbitrage opportunities are available, the current 1-year risk-free VKN interest rate is closest to:

A 5.3%.

Because the PKR is trading at a forward premium (the forward VKN/PKR exchange rate is greater than the spot VKN/PKR exchange rate), the VKN interest rate must be greater than the PKR interest rate. VKN should have an interest rate higher than that for PKR by the amount of the forward premium, or approximately 3.0% + 2.3% = 5.3%.

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