Question

Consider the following market information: Spot rate for the Canadian dollar C$....$0.80 90 day forward rate for the C$........$0.79 90 day Canadian interest rate….....4% 90 day U.S. interest rate……………2.5% (1)Given this information, would it be feasible for a U.S. investor with US$1 million to engage in covered interest arbitrage? Provide quantitative explanation. (11)If covered interest arbitrage is feasible, determine the profit the investor could earn. (111)Is there evidence of interest rate parity between U.S and Canada? Explain.

Answer 1

	Forward rate= USD per CD* (1+Interest rate in USA)/(1+Interest rate in Canada)
	Forward rate=	=0.8*(1+0.025)/(1+0.04)
	Per USD	0.7885
	Since given forward rate is also 0.79, we can see that there is some arbitrage opportunity is not available
	So the funds available are invested in Canada
	Equivelent Canadian Dollars	=1000000/0.8
		1250000
	This is invested in Canda for 90 days	=1250000*(1+4%)
		1,300,000
	Amount converted back to USD	=1300000*0.79
		1,027,000
	Amount in USD if invested in USA	=1000000*(1+2.5%)
		1,025,000
	So this way there will be Gain of	2,000