The interest rates in Canada and the United States are 7% and 6% per annum, resp
ID: 447764 • Letter: T
Question
The interest rates in Canada and the United States are 7% and 6% per annum, respectively, with continuous compounding. The spot price of the Canadian dollar is $0.7000. The forward price for a contract deliverable in one year is $0.6900.
Does interest rate parity exist? If it does exist, then show why it exists. If interest rate parity does not exist, then show whether covered interest arbitrage is possible for Canadians or Americans. If covered interest arbitrage is possible, what is the annual rate of return with continuous compounding?
Explanation / Answer
If interest rate parity exists, then the return for U.S. investors who use coveredinterest arbitrage will be the same as the return for U.S. investors who invest in U.S.Treasury bills.
Covered interest arbitrage exists for Canadians, if a Canadian makes more than 6% (continuous compounding) from the following: selling Canadian dollars in the spot market, depositing US dollars in a US bank for one year, and buying Canadian dollars forward. Covered interest arbitrage exists for Americans, if an American makes more than 5% (continuous compounding) from the following: buying Canadian dollars in the spot market, depositing Canadian dollars in a Canadian bank for one year, and selling Canadian dollars forward.
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