Suppose the 1-year risk-free rate of return in Canada is 4% and the 1-year risk-free rate of return in Britain is 6%.The current exchange rate is 1 pound = Cad.$1.67.A 1-year future exchange rate of __________ for the pound would make a Canadian investor indifferent between investing in the Canadian security and investing in the British security.

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Quizplus · Accepted Answer

To make a Canadian investor indifferent between investing in Canada and Britain, the future exchange rate should offset the interest rate differential. The formula for calculating the future exchange rate, given the interest rate differential, is:$$ \text{Future Exchange Rate} = \text{Current Exchange Rate} \times \frac{1 + \text{Interest Rate of Foreign Country}}{1 + \text{Interest Rate of Home Country}} $$Plugging in the given values:$$ \text{Future Exchange Rate} = 1.67 \times \frac{1 + 0.06}{1 + 0.04} = 1.67 \times \frac{1.06}{1.04} = 1.67 \times 1.0192 = 1.7021 $$The closest option to this calculated future exchange rate is 1.6385 (Option A), which would make a Canadian investor indifferent between investing in Canada or Britain by offsetting the higher British interest rate with a depreciation of the pound against the Canadian dollar.

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