Question

Suppose the one year forward quote for the Canadian Dollar is 0.7642 USD = 1 CAD. The spot quote is 0.7496 USD = 1 CAD. Canada has 7.07% one-year interest rates. If interest rate parity holds, what is the one-year interest rate in the U.S.?

Answer 1

Interest rate parity: it states that the size of the the forward premium or discount should be equal to the interest rate differential between the two countries concerned.

Spot rate (S) =0.7496 USD per 1 CAD

1 year Forward rate (F) = 0.7642 USD per 1 CAD

Here the rate is mentioned as USD per CAD , so the domestic country will be considered as US and the foreign country will be considered as Canada.

As per the interest rate parity,

(1+Home country interest rate) = (F/S)(1+Foreign country interest rate)

Here Canada interest rate is given.i.e, Foreign country interest rate is given = 7.07%.

So, we need to find out the home country interest rate i.e, US interest rate.

(1+home country interest rate) =(0.7642/.7496)*(1+0.707)

(1+Home country interest rate)= (1.01948)*(1.0707)

(1+Home country interest rate)=1.09156

Home country interest rate= 0.09156 i.e,9.156%

Interest rate in US = 9.156%.

Here we can observe that as the forward dollar rate has been decreased and it has been compensated by the higher interest rate in US. It defines the interest rate parity.

Interest rate in US = 9.156%.