Assume that the one-year interest rate in Canada is 4 percent. The one-year U.S. interest rate is 8 percent. The spot rate of the Canadian dollar (C$) is $.94. The forward rate of the Canadian dollar is $.98.

 a. Is covered interest arbitrage feasible for U.S. investors? Show the results if a U.S. firm engages in covered interest arbitrage to support your answer.

b. Assume that the spot rate and interest rates remain unchanged as coverage interest arbitrage is attempted by U.S. investors. Do you think the forward rate of the Canadian dollar will be affected? If so, state whether it will increase or decrease, and explain why.

Ans a)It can be concluded that covered interest arbitrage is feasible for US investors and they will earn a profit of $4 as a result of such an arbitrage opportunity.

Ans b)Since the fair forward rate that is calculated as per the Interest rate parity theory of $0.97 is different from the forward rate quoted by the bank, therefore, we can conclude that the forward rate of the Canadian dollar will be affected and it will increase by the following amount:-

Increase in the forward rate of Canadian dollar=0.978-0.94

=$0.038

Step-by-step explanation

Ans a)- The following information has been provided in the question:-

One-year interest-rate in Canada=4%

One year US interest rate =8%

The spot rate of the Canadian Dollar(C$)=$0.94

The forward rate of the Canadian Dollar=$0.98

The covered interest arbitrage is calculated as follows:-

Borrow $1000 from US banks at the rate of 8%.i.e. one -year US interest rate

Therefore, the amount payable to the bank after one year =$1000+$1000*8/100

=$1000+$80

=$1080

The next step will be to buy Canadian dollar at the spot rate of 0.94

So, the amount of Canadian dollar that is borrowed will be calculated as follows:-

The amount borrowed in Canadian dollar=Amount borrowed from US bank/Spot rate of the Canadian dollar

=$1000/0.94

=$1063.82 or $1064

The next step will be to invest this amount of $1064 in Canada at the rate of 4%. The amount that will be received after one year will be calculated as follows:-

Amount to be received after one year=$1064+4%*$1064

=$1064+4/100*$1064

=$1064+$42.56

=$1106.56 or $1106

The next step will be to buy US dollars at the forward rate of $0.98. So,the amount bought will be calculated as follows:-

Amount bought =$1106*$0.98

=$1083.88 or $1084

At last, the bank loan will be paid and the amount of profit earned in this arbitrage opportunity will be calculated as follows:-

Amount of profit=$1084-$1080

=$4

Therefore, it can be concluded that covered interest arbitrage is feasible for US investors and they will earn a profit of $4 as a result of such an arbitrage opportunity.

Ans b)In order to determine whether the forward rate of the Canadian Dollar will be affected or not we can apply the formula of covered interest rate parity theory in order to determine the forward rate of the Canadian dollar as follows:-

Forward rate($/Canadian dollar)=Spot rate($/Canadian Dollar)[1+Periodical inflation rate of US )/(1+Periodical inflation rate of Canada)

Here, spot rate ($/Canadian dollar)=0.94*[(1+0.08)/(1+0.04)]

=0.94*1.08/1.04

=0.976

Since the fair forward rate that is calculated as per the Interest rate parity theory of $0.97 is different from the forward rate quoted by the bank, therefore, we can conclude that the forward rate of the Canadian dollar will be affected and it will increase by the following amount:-

Increase in the forward rate of Canadian dollar=0.978-0.94

=$0.038