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Assume the spot rate on the Canadian dollar is C$1.1847. The risk-free nominal rate in the U.S. is 5 percent while it is only 4 percent in Canada. What one-year forward rate will create interest rate parity?

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jepessoa

Answer:

C$1.1734

Explanation:

Interest rate parity refers to the relationship between interest rates and the value of currencies. In order to achieve interest rate parity, the hedged returns from investing in Canadian or US dollars should be the same in one year.

Forward rate / spot rate = (1 + risk free rate Canada) / (1 + risk free rate US)

Forward rate / C$1.1847 = 1.04 / 1.05 = 0.9905

Forward rate = 0.9905 x C$1.1847 = C$1.1734

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