Suppose the following conditions exist between the U.S. and Canada. U.S. interest rate = 4.5%. Canadian...

Suppose the following conditions exist between the U.S. and Canada. U.S. interest rate = 4.5%. Canadian interest rate = 3.4%. Spot rate: 1 CAD = .9537 USD. 6 month forward rate: 1 CAD = .9612 USD. Are the conditions of interest rate parity violated? If so, what would be our profit if we engaged in covered interest arbitrage with $2M?

	A.	Interest rate parity is not violated- no opportunity
	B.	Yes, interest rate parity is violated. We can make a profit of $4,995.60 with our $2M.
	C.	Yes, interest rate parity is violated. We can make a profit of $5,655.90 with our $2M.
	D.	Yes, interest rate parity is violated. We can make a profit of $2,887.32 with our $2M.

Solutions

Expert Solution

As per Interest Rate Parity,

Theoretical Forward Rate $/CAD = Spot $/CAD*(1+Interest Rate on $)/(1+Interest Rate on Candian $)

= 0.9537*[1+(0.045/2)]/[1+(0.034/2)]

= 0.9589

Actual Forward Rate < Theoretical Forward Rate

As the Rates are different, Interest Rate Parity(IRP) DOES NOT exist i.e. Conditions ARE VIOLATED

Actual Forward Rate of CAD is Overvalued

To make an Arbitrage Gain, Buy CAD in Spot and Sell in Forward

Steps to make an Arbitrage Gain:

Now,

(1) Borrow $2000000 for 6 months

(2) Buy CAD at Spot Rate using $2000000 and receive 2000000/0.9537 = CAD 2097095.5227

(3) Invest CAD 2097095.5227 for 6 months

(4) Enter into Forward Contract to Sell 2097095.5227*(1+0.017) = CAD 2132746.146

After 6 months,

(5) Realize Investments and receive 2097095.5227*(1+0.017) = CAD 2132746.146

(6) Sell CAD 2132746.146 under Forward Contract and receive 2132746.146*0.9612 = $2049995.596

(7) Repay the borrowings along with interest and pay 2000000*(1+0.0225) = $2045000

(8) Arbitrage Gain = Difference = $2049995.596 - $2045000 = $4995.6

jeff jeffy answered 2 years ago

Next > < Previous

Related Solutions

Suppose the following conditions exist between the U.S. and Canada. U.S. interest rate = 3.22%. Canadian...

Suppose the following conditions exist between the U.S. and Canada. U.S. interest rate = 3.22%. Canadian interest rate = 3.1%. Spot rate: 1 CAD = .9601 USD. 6 month forward rate: 1 CAD = .9622 USD. Are the conditions of interest rate parity violated? If so, what would be our profit if we engaged in covered interest arbitrage with $10M?

Suppose interest rate differentials between the US and Japan is 4.5 percent and the yen is...

Suppose interest rate differentials between the US and Japan is 4.5 percent and the yen is in 5.1 percent premium 1-year forward. The U.S. interest rate is 6 percent, while Japanese Interest rate is 1.5 percent. Assume you can borrow $10 millions or its yen equivalent. Is there an arbitrage profit, if so how much. Provide your solution assuming Japanese spot rate is 92 yen/$.

Discuss the following... a. "A strong Canadian dollar is in the interest of Canada." Is this...

Discuss the following... a. "A strong Canadian dollar is in the interest of Canada." Is this statement true? Justify your answer. b. How is a change in the interest rate likely to affect an economy? The Minister for Finance has been advised to that to stimulate economic growth, he should use the interest rate as a policy instrument and a fixed exchange rate. Evaluate this advice.

The U.S. interest rate is7 percent and the Canadian dollar’s interest rate is 6 percent. The...

The U.S. interest rate is7 percent and the Canadian dollar’s interest rate is 6 percent. The Canadian dollar's forward rate has a premium of 2 percent. (1) Calculate the effective financing rate for U.S. firms. (2) Does interest rate parity hold? (3) Could U.S. firms lock in a lower financing cost by borrowing Canadian dollars and purchasing Canadian dollars forward for one year? Explain.

The following conditions exist in the foreign exchange market: Current spot rate: 0.876 Euros / U.S....

The following conditions exist in the foreign exchange market: Current spot rate: 0.876 Euros / U.S. $ Annualized interest rate on 90-day dollar-denominated bonds: 4% Annualized interest rate on 90-day Euro-denominated bonds: 3% All financial investors expect the spot exchange rate to be 0.85 Euros / U.S. $ in 90 days. If a U.S. investor bases decisions solely on the expected rate of return, should that investor buy Euro-denominated bonds or dollar-denominated bonds? Briefly explain. If a European investor bases...

1 When the Bank of Canada lowers the overnight rate, the Canadian interest rate differential ________...

1 When the Bank of Canada lowers the overnight rate, the Canadian interest rate differential ________ and the Canadian dollar ________ on the foreign exchange market. A) increases; appreciates B) increases; depreciates C) decreases; appreciates D) decreases; depreciates E) decreases; reaches interest rate parity 2. When real GDP is less than potential GDP, an increase in the quantity of money leads to a(n) A) increase in both real GDP and the price level. B) decrease in real GDP and an...

Suppose the current exchange rate is $1.62/£, the interest rate in the united states is 4.5%,...

Suppose the current exchange rate is $1.62/£, the interest rate in the united states is 4.5%, the interest rate in the United Kingdom is 4%, and the volatility of the $/£, exchange rate is 16%. (a) Using the Black-Scholes formula, calculate the price of a six-month European call option on the British pound with a strike price of $1.60/£ The price of a six-month European call option is__________ $ (round to five decimal places).

Assume the following information regarding U.S. and Canadian annualized interest rates: Currency Lending Rate Borrowing Rate...

Assume the following information regarding U.S. and Canadian annualized interest rates: Currency Lending Rate Borrowing Rate U.S Dollar ($) 5.89% 6.35% Canadian Dollar (C$) 5.6% 6% Piggy Bank can borrow either $20 million or C$30 million. Furthermore, Piggy Bank expects the spot rate of the Canadian dollar to be $0.82 in 60 days (the current spot rate is $0.80). 8. What is the profit or loss from Piggy Bank's speculation if the spot rate 60 days from now is indeed...

The spot rate between Canada and the U.S. is Can$1.2449/$, while the one-

The spot rate between Canada and the U.S. is Can$1.2449/$, while the one-year forward rate is Can$1.2448/$. The risk-free rate in Canada is 4.65 percent and risk-free rate in the United States is 2.77 percent. How much in profit can you earn on $12,500 utilizing covered interest arbitrage?

Suppose the interest rate on a 1-year Canadian Treasury bill is 1.53 percent and the interest...

Suppose the interest rate on a 1-year Canadian Treasury bill is 1.53 percent and the interest rate on a 1-year U.S. Treasury bill is 1.7 percent. Assuming uncovered interest parity holds, we would expect a) the Canadian dollar to appreciate against the U.S. dollar 0.17 percent. b) the Canadian dollar to depreciate against the U.S. dollar by 0.17 percent. c) the nominal exchange rate between Canadian dollars and the U.S. dollar ($Ca/$US) to grow by 0.17 percent. d) Both a...

Subjects