In: Finance
Assume a risk-free asset in the U.S. is currently yielding 1.9
percent while a Canadian risk-free asset is yielding 2.3 percent.
The current spot rate is CAD1.361. What is the approximate 2-year
forward rate if interest rate parity holds?
CAD1.3688
CAD1.3719
CAD1.3754
CAD1.3786
CAD1.3799
Solution :
As per the Interest rate Parity model
Exchange rate differential = Interest rate differential
( Forward Rate / Spot Rate ) = [( 1 + Risk free Rate in Currency A ) / ( 1 + Risk free Rate in Currency B )] n
Where n = No. of years
As per the Information given in the question we have
Spot rate of the Dollar is = CAD 1.361 ; Thus CAD / $ = A / B = CAD 1.361 ;
Canadian Risk free Interest rate = Risk free Rate in Currency A = 2.3 % = 0.023 ;
U.S. Risk free Interest rate = Risk free Rate in Currency B = 1.9 % = 0.019 ;
n = 2 Years ;
Applying the above values in the formula / Equation we have
Forward Rate / 1.361 = [ ( 1 + 0.023 ) / ( 1 + 0.019 ) ] 2
Forward Rate = [ 1.023 / 1.019 ] 2 * 1.361
Forward Rate = [ 1.004 ] 2 * 1.361
Forward Rate = 1.008 * 1.361
Forward Rate = 1.3719 CAD
The approximate 2-year forward rate if interest rate parity holds = 1.3719 CAD
The solution is Option 2 = CAD 1.3719
Note : ( 1.004 ) 2 is calculated using the excel function =POWER(Number,Power) = POWER(1.004,2) = 1.008