Suppose 1 U.S.dollar equals 1.60 Canadian dollars in the spot market.6-month Canadian securities have an annualized return of 6% (and thus a 6-month periodic return of 3%).6-month U.S.securities have an annualized return of 6.5% and a periodic return of 3.25%.If interest rate parity holds, what is the U.S.dollar-Canadian dollar exchange rate in the 180-day forward market?

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Quizplus · Accepted Answer

From the interest rate parity formula it follows that
 11ea1b84_8bd3_38f4_a54a_3901cd412540_TB3581_00 Another way to think of this is $1 invested today in the United States yields $1.0325 six months from now.Alternatively, investors could put their money in Canadian securities.In this case, the investor would exchange $1 today for 1.6 Canadian dollars.This money could be invested in Canada and after 6 months this investment would be worth 1.6480 Canadian dollars[(1.6)(1.03)].At a forward exchange rate of 1 U.S.dollar equals 1.5961 Canadian dollars, 1.6480 Canadian dollars would be worth $1.0325 in the U.S.Since the 2 investments produce the same return, interest rate parity holds.