Suppose the spot exchange rate for the Canadian dollar is Can$1.01 and the six-m

Question

Suppose the spot exchange rate for the Canadian dollar is Can$1.01 and the six-month forward rate is Can$1.03. (Enter your answer as directed, but do not round intermediate calculations.)

Assuming absolute PPP holds, what is the cost in the United States of an Elkhead beer if the price in Canada is Can$2.49? (Round your answer to 2 decimal places (e.g., 32.16).)

Suppose the spot exchange rate for the Canadian dollar is Can$1.01 and the six-month forward rate is Can$1.03. (Enter your answer as directed, but do not round intermediate calculations.)

Explanation / Answer

A) US Dollar

Explanation

Since for 1 US Dollar, you can get 1.01 Canadian Dollar, it means that US Dollar is worth more.

B) Absolute Purchasing Power Parity is based on the law of one price, that is, the real price of the good must be same across all the countries.

Assuming that it holds, and taking the exchange rate as Can$1.01/ USD,

if price of a beer in Canada is Can$2.49, then its price in US Dollars = 2.49/1.01 = US$2.47

C) A currency is quoted at a forward premium relative to a second currency if the forward price (in units of the second currency) is greater than the spot price. Otherwise, it is trading at a forward discount.

That is, if forward exchange rate A/B is more than the spot rate A/B, we say that B (base currency) is trading at a premium in the forward market.

Spot Rate - Can$1.01/USD

6M Forward Rate - Can$1.03/USD

where, USD is the base currency.

Since, forward rate is more than the spot rate, US Dollar is trading at a premium to the Canadian Dollar.

D) Forward Rate is nothing, but the expected future spot rate.

Spot Rate - Can$1.01/USD

It means, for 1 USD, you will get 1.01 Canadian Dollars today.

6M Forward Rate - Can$1.03/USD

It means that it is expected that you will get Can$1.03 for 1USD in 6months

Since forward rate is more than the spot rate, it means that US Dollar is expected to appreciate.

E) Canada

Explanation

As per covered interest rate parity, forward premium or discount should exaclty offset the differences in the interest rates, so that an investor would earn the same return investing in either country.

FA/B = SA/B * (1+RA) / (1+RB)

where,

A is Canadian Dollar and B is US Dollar

RA and RB are interest rates in Canada and US respectively

FA/B = 1.03

SA/B = 1.01

1.03 = 1.01 * (1+RA) / (1+RB)
For this equation to be in balace, RA has to be more than RB

This means that interest rate in Canada should be more than the interest rate in the US.

Depreciation of the Canadian Dollar relative to the US Dollar will offset the higher Canadian interest rates with respect to the US interest rates.

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