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Consider a Canadian investor with C$1,000 (Canadian dollar) to place in a bank deposit in either...

Consider a Canadian investor with C$1,000 (Canadian dollar) to place in a bank deposit in either US or Canada. The (one-year) interest rate on bank deposits is 2% in US and 4% in Canada. The (one-year) forward US dollar ($) – Canadian dollar (C$) exchange rate is 1.4 C$ per $ and the spot rate is 1.3 C$ per $. Answer the following questions, using the exact equations for UIP and CIP as necessary.

a. What is the C$-denominated return on Canadian deposits for this investor?

b. What is the (riskless) C$-denominated return on US deposits for this investor using forward cover?

c. Is there an arbitrage opportunity here? Explain why or why not. Is this an equilibrium in the forward exchange rate market?

d. If the spot rate is 1.3 C$ per US dollar, and interest rates are as stated previously, what is the equilibrium forward rate, according to CIP?

e. Suppose the forward rate takes the value given by your answer to (d). Calculate the forward premium on the US dollar for the Canadian investor (where exchange rates are in C$ per US dollar). Is it positive or negative? Why do investors require this premium/discount in equilibrium?

f. If UIP holds, what is the expected depreciation/appreciation of the C$ against the US dollar over one year?

g. Based on your answer to ( f ), what is the expected C$–US dollar exchange rate one year ahead?

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