The spot rate for the Japanese yen currently is ¥117 per $1. The one-year forward rate is ¥116 per $1. A risk-free asset in Japan is currently earning 4 percent. If interest rate parity holds, what rate can
You earn on a one-year risk-free Canadian security?

Question

Quizplus · Accepted Answer

According to interest rate parity, the difference in interest rates between two countries should equal the percentage difference between the forward exchange rate and the spot exchange rate. In this case, the forward rate is ¥116 per $1, which is a 1.71% decrease from the spot rate of ¥117 per $1. The interest rate in Japan is 4%, so to find the equivalent risk-free rate in Canada, we use the formula:

(1 + Canadian Interest Rate) = (1 + Japanese Interest Rate) x (Forward Rate / Spot Rate)

(1 + Canadian Interest Rate) = (1 + 4%) x (¥116/$1) / (¥117/$1)
(1 + Canadian Interest Rate) = 1.04 x 0.9914
(1 + Canadian Interest Rate) = 1.0328
Canadian Interest Rate = 0.0328 or 3.28%

Therefore, the answer is D, 4.90 percent, which is the closest choice to the calculated rate.

The Spot Rate for the Japanese Yen Currently Is ¥117