7) Assume that you can borrow or lend in the US for 2-years at a 4% (annual) rat
ID: 2810504 • Letter: 7
Question
7) Assume that you can borrow or lend in the US for 2-years at a 4% (annual) rate, and assume that you can borrow or lend in Canada at a 6% (annual) rate. Further assume that the current exchange rate is.99 s/CS. What 2-year forward rate would you quote on the Canadian dollar? If UIP holds, what exchange rate do you expect in two years? If expected inflation is 2% annually in the US, what is expected inflation in Canada if PPP holds? On average, do you expect to get higher real returns if you hold US or Canadian dollars for the next two years?Explanation / Answer
Current Exchange rate = $0.99 / C$
Interest rate in USA = 2%
Interest rate in Canada = 6%.
According to the UIP, Forward exchange rate after one year is calculated below:
Forward rate = Spot Rate × (1 + Canada Rate) / (1 + US rate)
= $0.99 × (1 + 6%) / (1 + 2%)
= $0.99 × 1.0392
= $1.2882
According to the UIP, exchange rate after one year will be $1.2882 per Canadian dollar.
Again.
Inflation rate in USA = 2%
Spot rate = $0.99 / C$
Forward rate = $1.2882 per C$
Inflation rate in Canada = (1 + US inflation) / (Forward rate / Spot rate) - 1
= (1 + 2%) / (1.2882 / 0.99) - 1
= (1.02 / 1.3922) - 1
= 0.9815 - 1
= -1.85%
Inflation rate in Canada is -1.85% if PPP holds true.
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