Question

The current spot rate is C$1.377 and the one-year forward rate is C$1.316. The nominal risk-free rate in Canada is 4 percent while it is 8 percent in the U.S. Using covered interest arbitrage you can earn an extra _____ profit over that which you would earn if you invested $1 in the U.S.

Answer Options:

$0.0861

$0.0779

$0.0482

$0.0082

$0.0000

Answer 1

If You want to Invest in USD, Take loan in Opposite country, I.e Take Loan in Canada for 1 Year

Amount to be borrowed in (C$) to Invest 1USD in USA today:

Today 1 USD = C$ 1.377

Thus take loan of C$ 1.377 & convert the same into USD using Spot rate & enter into Fwd transaction.

Deposit the converted amount in USA.

Maturity proceedings in USD after 1 Year:

Amount = Principal * (1+r)

= 1 USD * (1+0.08)

= 1.08 USD

Reconvert these proceeds into C$ using Forward rate ( At the begining of the year you enter into Fwd contract )

Amount in C$ = 1.08 USD * 1.316

= C$ 1.4213

Repay the loan borrowed in caanda along with Int:

Maturity of loan taken

Amount = Principal * (1+r)

= C$ 1.377 * 1.04

= C$ 1.4321

Book Profit = Proceeds from USD deposit - Proceds of C$ Loan

= C$ 1.4213 - $ C$ 1.4321 i.e Loss of C$ 0.0108

COnverted in to USD using Fwd rate = 0.0108 / 1.316

= Loss of USD 0.0082

i.e Profit "0" not advicable to borrw in C$ & Invest In USD

Part 2:

If You want to Invest in C$, Take loan in Opposite country, I.e Take Loan in USA for 1 Year

Amount to be borrowed in (USD) to Invest C$ in Canada today:

Today 1 USD = C$ 1.377

Thus take loan of 1USD & convert the same into C$ using Spot rate & enter into Fwd transaction.

Deposit the converted amount in C$.

Maturity proceedings in C$ after 1 Year:

Amount = Principal * (1+r)

= 1.377 C$ * (1+0.04)

= 1.4321 C$

Reconvert these proceeds into USD using Forward rate ( At the begining of the year you enter into Fwd contract )

Amount in USD = C$ 1.4321 / 1.316

= 1.0882 USD

Repay the loan borrowed in USA along with Int:

Maturity of loan taken

Amount = Principal * (1+r)

= 1 USD * 1.08

= USD 1.08

Book Profit = Proceeds from USD deposit - Proceds of C$ Loan

= USD 1.0882 - USD 1.08 i.e Profit of USD 0.0082

Excess profit can be aachieved is USD 0.0082 i.e Option D is correct.