The current spot rate is C$1.1578 and the one-year forward rate is C$1.1397. The nominal risk-free rate in Canada is 5 % while it is 6 % in the U.S. Using covered interest arbitrage you can earn an extra _____ profit over that which you would earn if you invested $1 in the U.S.

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Quizplus · Accepted Answer

Covered interest arbitrage involves taking advantage of the interest rate differential between two countries while covering your exchange rate risk with a forward contract. To calculate the profit, we compare the outcome of investing $1 in the U.S. at 6% interest with the outcome of converting $1 to Canadian dollars, investing at the Canadian interest rate of 5%, and then converting back to U.S. dollars at the forward rate.1. Investing $1 in the U.S. at 6% for one year yields $1.06.2. Converting $1 to Canadian dollars at the spot rate gives $1/1.1578 = C$0.8631.3. Investing C$0.8631 in Canada at 5% for one year yields C$0.8631 * 1.05 = C$0.9063.4. Converting C$0.9063 back to U.S. dollars at the forward rate gives C$0.9063/1.1397 = $0.7953.The difference between investing in the U.S. and using covered interest arbitrage is $1.06 - $0.7953 = $0.2647. However, this calculation seems to have a mistake in the conversion back to U.S. dollars, which should correctly reflect the profit from the arbitrage strategy. Let's correct the approach:1. $1 invested in the U.S. grows to $1 * 1.06 = $1.06.2. $1 converted to CAD at the spot rate: $1 / 1.1578 = C$0.8635.3. C$0.8635 invested in Canada at 5% grows to C$0.8635 * 1.05 = C$0.9067.4. C$0.9067 converted back to USD at the forward rate: C$0.9067 / 1.1397 = $0.7957.The correct approach to find the arbitrage profit involves comparing the outcomes after accounting for the interest rates and exchange rates correctly. The mistake in the conversion step led to an incorrect conclusion. The correct calculation should focus on the arbitrage opportunity presented by the difference in interest rates and the forward exchange rate, which does not directly yield the options provided. Let's correct the final step based on the initial setup:1. Convert $1 to CAD at the current spot rate: $1 * 1.1578 = C$1.1578.2. Invest C$1.1578 in Canada at 5% for one year: C$1.1578 * 1.05 = C$1.2157.3. Convert back to USD at the forward rate: C$1.2157 / 1.1397 = $1.0667.The profit over investing $1 in the U.S. at 6% (which would yield $1.06) is $1.0667 - $1.06 = $0.0067, which corresponds to option B.

The Current Spot Rate Is C$1