Question

1. An investor has $1,000 that can be invested in the U.S.A or Canada in one–year bonds.

   The current yield on the bonds are rus = 5.5% and rcan = 4%.

   Suppose the current exchange rate is US$1 for Cdn$1.20, but you expect the US dollar to depreciate to US$1 for Cdn$1.10 a year from now. Abstracting from everything else, which country offers a better investment opportunity? Explain. [Hint: apply the interest rate parity]

Answer 1

Answer- Canada offers a better investment opportunity because it gives higher return on investment of $1000.

If the amount of $1000 will be invested in the U.S.A. bond at 5.5% rate of return.

Yeild= 1000*5.5%= $55

Total value of bond is US $1055.

If the amount will be invested in Canadian bond at 4% rate of return.

Given the spot exchange rate is 1.20/Cdn $

$ 1000= Cdn$ 1000*1.20 =Cdn$ 1200.

Yield=1200*4%= Cdn$ 48.

Total value of bond is Cdn$ 1248.

As per question after one year the U.S. dollar to depreciate to U.S $1= Cdn$ 1.10

Value of Canadian bond in U.S. $ = 1248/1.10

=U.S. 1134.55.

That means, if the amount will be invested in Canadian bond it will given greater return (1134.55-1055= $79.55) than U.S. bond.