Question

(a) Suppose a fund owns stocks in a foreign country. State the two sources of fluctuation in fund value.

(b) The current exchange rate is $1.5 Canadian per one Euro. The Canadian risk free rate is 5%, and the Euro risk free rate is 1% (compounded continuously). Calculate both the no arbitrage forward price and the prepaid forward price in Canadian dollars for a one year forward contract on the CAD-EUR exchange rate.

Answer 1

(a) Sources of fluctuation in value of fund Invested in stocks of foreign Country:

1. Change in Interest Rates (either in home country or foreign country)

2. Changes in Exchange Rates.

(b) As per Interest Rate Parity Theorem: (Let € = x C$),

Then, after 1 year € ( 1 + I_€ ) = x C$ ( 1+ I_C$ )

Given, Risk free Rate of Canadian $ (I_C$) = 5%; Risk free Rate of Euro (I_€) = 1%

€ 1 = C$ 1.5

After 1 Year, € 1*(1.01) = C$ 1.5*(1.05)

€ 1 = C$ 1.5*(1.05)/(1.01)

Therefore no arbitrage forward price 1€ = C$ 1.5594

Prepaid forward price in Canadian dollars for 1 year forward = C$ 1.5594/1.05 = C$ 1.4851.