4. Using Spot and Forward Exchange Rates [LO1] Suppose the spot exchange rate fo

Question

4. Using Spot and Forward Exchange Rates [LO1] Suppose the spot exchange rate for the Canadian dollar is Can$1.09 and the six-month forward rate is Can$1.11.

a. Which is worth more, a U.S. dollar or a Canadian dollar?

b. Assuming absolute PPP holds, what is the cost in the United States of an Elkhead beer if the price in Canada is Can$2.50? Why might the beer actually sell at a different price in the United States?

c. Is the U.S. dollar selling at a premium or a discount relative to the Canadian dollar?

d. Which currency is expected to appreciate in value?

e. Which country do you think has higher interest rates--the United States or Canada? Explain

[LO2] The treasurer of a major U.S. firm has $30 million to invest for three months. The interest rate in the United States is .31 percent per month. The interest rate in Great Britain is .34 percent per month. The spot exchange rate is £.573, and the three-month forward rate is £.575. Ignoring transaction costs, in which country would the treasurer want to invest the company's funds? Why?

Explanation / Answer

1
US dollar is worth more because 1 USD is able to buy more than 1 Canadian Dollar
2
Price of beer in Canada=2.5
So, Price of beer in US=2.5/1.09=2.2935
Different price because of exchange rate..
3
As forward is more than spot, it is premium
4
USD is excpected to appreciate because Forward rate is increasing in value
5
The country whose inerest rates is lower will trade at forward premium and since here US is trading at premium, US is having low interest rates and Canada is having high interest rates

Investment after 3 months in US in dollars=30*1.0031^3=30.27987 million dolalrs

Investment after 3 months in UK in pounds=30*0.573*1.0034^3=17.36593 million pounds
In dollars=17.36593/0.575=30.20162

As we see investment in US becomes more than in UK. SO, he should invest in US

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