International Finance Theory and Policy
by Steven M. Suranovic

Finance 20

Finance 20

Finance Questions 20 2-1

1. The covered interest parity condition substitutes the forward exchange rate for the expected exchange rate. The condition is labeled covered because the forward contract assures a certain rate of return (i.e. without risk) on foreign deposits. In the Table below is listed a spot exchange rate, a 90-day forward rate, and a 90-day money market interest rate in Germany and Canada. Use this info to answer the following questions.

  Germany Canada
Spot ER .5841 $/DM .7451 $/C$
90-day For-ER .5807 $/DM .7446 $/C$
90-day Interest Rate 1.442% .875%

A. What would the US 90-day interest rate have to be for the US to have the highest rate of return for a US investor? (Use the exact formulae to calculate the rates of return.)

B. If spot exchange rates move until covered-interest parity holds exactly, then would you expect the Canadian dollar to appreciate or depreciate with respect to the DM on the next day of trading? Explain why.

International Finance Theory and Policy - Chapter 20: Last Updated on 1/6/08