Question

3. Assume the following information: Quoted Price Spot rate of Canadian dollar $0.81 90day forward rate of Canadian dollar $0.79 90day Canadian interest rate 4% (per 90 days) 90day U.S. interest rate 2.5% (per 90 days) a) Given this information, what would be the yield (percentage return) to a U.S. investor who used covered interest arbitrage? (Assume the investor invests $1,000,000.) b) The forward rate should rise, True or False?

Answer 1

a) : Yield to U.S. investor:

Spot Rate :1 Canadian Dollar = $0.81

Forward Rate : 1 Canadian Dollar = $0.79

Convert $ 10,00,000 into Canadian dollar using Spot rate = 10,00,000/0.81 = Can Dollar 12,34,568

Invest Canadian Dollar 12,34,568 for 90 days at 4 % rate

Amount receive after 90 days = 1234568* (1+0.04) = 1283951

Convert Canadian Dollar 1283951 using forward rate

Amount Receive = 1283951*0.79 = $ 10,14,321

Gain = $ 14321

Yield = 14321/1000000*100 = 1.43 %

b) : Forward Rate should rise. It is true. It should not be fall by more than 1.5% ( 4% -2.5%)

i.e. 0.81-( 0.81*1.5%) = .7978.

i.e. Forward Rate of 1 Canadian dollar price should be $ 0.7978