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Suppose mid-market USD/CAD spot exchange rate is 1.2500 CAD and one year forward rate is 1.2380...

Suppose mid-market USD/CAD spot exchange rate is 1.2500 CAD and one year forward rate is 1.2380 CAD. Also, the risk-free interest rate is 4% for USD and 3% for CAD. Which of the following value confirms that interest rate parity exists (Ratio of Forward to Spot)?

Solutions

Expert Solution

Interest Rate parity is a theory which gives the relationship between the interest rate of two provided currencies and spot and forward rate between two currencies

Covered Interest Rate parity exist when forward rate is used to prove that there is no arbitrage opportunity exits.

The Formula for covered interest rate parity is -

Here exchange rate is quoted as USD/CAD i.e. CAD per 1 USD, then USD is the base currency and CAD is the quote currency.

iquot = Interest free rate of return on deposits of quote currency. = 3%

ibase = Interest free rate of return on deposits of base currency. = 4%

n = number of years of forward rate. = 1 year

So If in above equation LHS = RHS then interest rate parity exists and there is no arbitrage opportunity.

Since LHS = RHS, so interest rate parity exists and there is no arbitrage opportunity.

jeff jeffy answered 1 year ago
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