Suppose that the risk-free rates in the United States and in Canada are 5% and 3%, respectively. The spot exchange rate between the dollar and the Canadian dollar (C$) is $0.80/C$. What should the futures price of the C$ for a one-year contract be to prevent arbitrage opportunities, ignoring transactions costs.
A) $1.00/C$
B) $0.82/C$
C) $0.88/C$
D) $0.78/C$
E) $1.22/C$

Question

Quizplus · Accepted Answer

The futures price can be calculated using the Interest Rate Parity (IRP) formula, which prevents arbitrage opportunities. According to IRP, the future exchange rate is determined by the formula: $F = S \times \frac{(1 + i_d)}{(1 + i_f)}$, where $F$ is the future exchange rate, $S$ is the spot exchange rate, $i_d$ is the domestic interest rate, and $i_f$ is the foreign interest rate. Plugging in the given values: $F = 0.80 \times \frac{(1 + 0.05)}{(1 + 0.03)} = 0.80 \times \frac{1.05}{1.03} = 0.80 \times 1.019417 = 0.8155336$, which rounds to $0.82/C$, thus preventing arbitrage opportunities.

Suppose That the Risk-Free Rates in the United States and in Canada