Suppose you observe the following spot and forward exchange rates between the US

Question

Suppose you observe the following spot and forward exchange rates between the US Dollar and the Canadian Dollar:

  Spot Exchange Rate One-Year Forward Exchange Rate

Canadian dollar (US Dollar/Canadian Dollar) 0.8932 0.9133

1. The current one-year interest rate on US Treasury securities is 6.89%. if interest rate parity holds, what is the expected yield on one-year Canadian securities of equal risk? A, 3.63% B. 4.54% C. 4.77% D. 3.86%

2. Which of the following statements is implied by interest rate parity theory?

A. A product bought in one country should have the same price in other countries, adjusted for exchange rate.

B. An investment in one's home country should have the same return as a similar investment in a doreign country.

C. If two countries have the same inflation rate, they should have the same interest rate too.

D. Interest rates in all countries with the same political risk should be the same.

Explanation / Answer

1 CAN $=0.8932 US $ (SPOT)

1 CAN $=0.9133 US $(1 YEAR FORWARD)

1. CALCULATION OF YIELD ON 1 YEAR CANADIAN SECURITY

APPLYING FORMULA,

1 YEAR FORWARD EXCHANGE RATE / SPOT EXCHANGE RATE = (1+INTEREST RATE OF US $) / (1+INTEREST RATE OF CAN $)

OR,0.9133/0.8932 = (1+0.0689) / (1+INTEREST RATE OF CAN $)

OR,1.0225=1.0689/(1+INTEREST RATE OF CAN $)

OR,(1+INTEREST RATE OF CAN $)=1.0454

OR,INTEREST RATE OF CAN $=1.0454-1

=0.0454

=4.54%

HENCE B.4.54% IS CORRECT

2.B.An investment in one's home country should have the same return as a similar investment in a doreign country.IS IMPLIED BY INTEREST RATE PARITY THEORY.CONSIDER A SITUATION WHERE INTEREST RATE IN INDIA AND US HAPPENS TO BE 10% AND 4% RESPECTIVELY.ANYONE WOULD FEEL LIKE EXPLOITING THIS INTEREST RATE DIFFERENTIAL AND CARRYING OUT ARBITRAGE .HOWEVER TO DO SO THE PERSON HAS TO TRAVEL THROUGH THE FOREX MARKET TWICE,ONCE TO SELL DOLLAR SPOT AND BUY DOLLAR FORWARD.IF MARKETS ARE EFFICIENT DOLLAR WILL BE AT A FORWARD PREMIUM APPROXIMATELY BY 6% AS A RESULT INVESTMENT IN INDIA WILL HAVE SAME RETURN AS A SIMILAR INVESTMENT IN US

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