The camera you want to buy costs $365 in the U.S. If absolute purchasing power p
ID: 2756024 • Letter: T
Question
The camera you want to buy costs $365 in the U.S. If absolute purchasing power parity exists, the identical camera will cost _____ in Canada if the exchange rate is C$1 = $0.7527. C$274.74 C$486.25 C$484.92 C$363.67 C$483.59 The current spot rate is C$1.376 and the one-year forward rate is C$1.318. The nominal risk-free rate in Canada is 4 percent while it is 8 percent in the U.S. Using covered interest arbitrage you can earn an extra _____ profit over that which you would earn if you invested $1 in the U.S. $0.0458 $0.0058 $0.0838 $0.0780 $0.0000
Explanation / Answer
1. As per Absolute Purchase power parity, the exchange rate represents the PPP.
Thus 1 CAD = 0.7527USd
1 USD = 1/0.7527 CAD
365 USD = 365 * 1/0.7527 = $484.92 choice C
2.
Borrow $1 in USA -> Due in 1 year at 8% = $1.08
Deposit CAD 1.376 -> in 1 year at 4% = 1.376*1.04 = 1.43104 CAD = USD 1.43104/1.318 = USD 1.085766
Extra profit = 1.085766 - 1.08 = USD 0.0058 i.e choice B
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