Suppose the 1-year risk-free rate of return in Canada is 5%.The current exchange rate is 1 pound = Cad $1.60.The 1-year forward rate is 1 pound = $1.57.What is the minimum yield on a 1-year risk-free security in Britain that would induce a Canadian investor to invest in the British security?

Question

Quizplus · Accepted Answer

To find the minimum yield required, we need to compare the returns of investing in Canada versus investing in Britain.
Investing in Canada:
Invest $1 CAD at 5% risk-free rate for 1 year, yielding $1.05 CAD in 1 year.
Investing in Britain:
Sell 1 CAD for 1.60 pounds.
Invest the 1.60 pounds in a risk-free security for 1 year.
In 1 year, obtain 1.60 x 1.07 = 1.712 pounds
Using the forward rate, 1.712 pounds can be exchanged for $1.57 CAD in 1 year.
Therefore, $1 CAD invested in Britain for 1 year will yield $1.57 CAD x (1.712 pounds / 1 pound) = $2.6898 CAD.
For a Canadian investor to be indifferent between investing in Canada or Britain, the yields of the two investments must be equal.
$1.05 CAD = $2.6898 CAD / (1 + r), where r is the yield of the British investment.
Solving for r, we get r = 6.998%, or approximately 7%.
Therefore, the minimum yield required on a 1-year risk-free security in Britain is 7%. 
Choice C is the closest option with a yield of 7.00%.

Suppose the 1-Year Risk-Free Rate of Return in Canada Is