A Canadian firm is considering purchasing a subsidiary in Great Britain. The subsidiary will cost $\le$16 million and will generate cash inflows of $\le$7.6 million per year at the end of each of the next three years. After that, the company will be worthless. The current exchange rate is $\le$0.83 British pounds per $1. The Canadian inflation rate is expected to be 4% over this period. The current risk-free rate of interest in Canada is 5% and the risk-free rate in Great Britain is 8%.

If interest rate parity holds, what is the one-year forward rate for exchanging pounds for dollars?

Question

A Canadian firm is considering purchasing a subsidiary in Great Britain. The subsidiary will cost

\le

16 million and will generate cash inflows of

\le

7.6 million per year at the end of each of the next three years. After that, the company will be worthless. The current exchange rate is

\le

0.83 British pounds per $1. The Canadian inflation rate is expected to be 4% over this period. The current risk-free rate of interest in Canada is 5% and the risk-free rate in Great Britain is 8%.

If interest rate parity holds, what is the one-year forward rate for exchanging pounds for dollars?

If interest rate parity holds, what is the one-year forward rate for exchanging pounds for dollars?

Quizplus · Accepted Answer

The one-year forward rate can be calculated using the interest rate parity (IRP) formula, which is $F = S \times \frac{(1 + i_{domestic})}{(1 + i_{foreign})}$, where $F$ is the forward rate, $S$ is the spot rate, $i_{domestic}$ is the domestic interest rate, and $i_{foreign}$ is the foreign interest rate. Substituting the given values: $F = 0.83 \times \frac{(1 + 0.05)}{(1 + 0.08)} = 0.83 \times \frac{1.05}{1.08} = 0.854$.

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