Suppose that the spot rate on the Canadian dollar is C$1.18. The risk-free nominal rate in the U.S. is 5 percent while it is only 4 percent in Canada. Which one of the following three-year forward rates best establishes the approximate interest rate parity condition?

Question

Quizplus · Accepted Answer

According to interest rate parity, the forward rate should reflect the difference in interest rates between two countries. In this case, the U.S. has a higher interest rate than Canada, so the forward rate should be lower than the spot rate (C$1.18). Choice B (C$1.145) reflects this by having a lower forward rate than the spot rate. Choices A, C, D, and E all have forward rates that are either too high or too low to reflect interest rate parity.

Suppose That the Spot Rate on the Canadian Dollar Is