Question

Suppose mid-market USD/CAD spot exchange rate is 1.2500 CAD and one year forward rate is 1.2380 CAD. Also, the risk-free interest rate is 4% for USD and 3% for CAD. Which of the following value confirms that interest rate parity exists (Ratio of Forward to Spot)?

Answer #1

Interest Rate parity states that Forward rate will be equal to Spot Rate (1+Interest rate CAD)/(1+Interest Rate USD)

It states that exchange rate will adjust to the interest rate differential between the two countries such that there is no advantage of investing in one country over another

Hence, forward rate as per IRPT = 1.2500(1+0.03)/(1.04)

= CAD1.2380/USD

Since actual forward rate is equal to fair forward rate, Interest Rate Parity exists.

Ratio of forward to spot = 1.2380/1.2500

= 99,04%

Ratio of interest rates = 1.03/1.04

= 99.04%

Hence, IRPT exists

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