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 percent while it is 6 percent 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.

Question

Quizplus · Accepted Answer

To determine the extra profit, we need to compare the return earned in Canada versus the return earned in the U.S.

Investing $1 in Canada at the risk-free rate of 5% would yield $1.05 after one year.

If we borrow $1 in the U.S. at the risk-free rate of 6%, we would owe $1.06 after one year.

At the current spot rate of C$1.1578, $1 would convert to C$1.1578.

If we use the one-year forward rate of C$1.1397, we could convert our C$1.1578 to $1.0122 after one year (C$1.1578 / C$1.1397 = $1.0122).

Therefore, we could borrow $1 in the U.S., convert it to C$1.1578 today, invest it in Canada at the risk-free rate of 5%, and convert it back to $1.0122 in one year using the forward rate. This would leave us with a profit of $0.0122.

Compared to investing $1 in the U.S. at the risk-free rate of 6%, which would yield $1.06 after one year, we can earn an extra $0.0067 ($0.0122 - $0.0055) by using covered interest arbitrage.

Therefore, the best choice is B, earning an extra $0.0067.

The Current Spot Rate Is C$1