The spot rate on the Canadian dollar is C$1.1578. The risk-free nominal rate in the U.S. is 7 % while it is only 5 % in Canada. What one-year forward rate will create interest rate parity?

Question

Quizplus · Accepted Answer

The correct answer is A because the forward rate that creates interest rate parity is C$1.1362. This is because the forward rate should be such that the expected return on a one-year investment in either currency is the same. In this case, the expected return on a one-year investment in Canadian dollars is 5%, while the expected return on a one-year investment in US dollars is 7%. To equalize the expected returns, the forward rate must be such that the expected depreciation of the Canadian dollar is 2%. This implies that the forward rate should be C$1.1578 * (1 - 0.02) = C$1.1362.

The Spot Rate on the Canadian Dollar Is C$1