Question

Suppose the interest rate on a one-year U.S. bond were 10 percent and the interest rate on an equivalent Canadian bond were 8 percent. If the interest-rate parity condition holds, is the U.S. dollar expected to appreciate or depreciate relative to the Canadian dollar over the next year?

You would expect the U.S. dollar to (Click to select) appreciate depreciate .

If the interest parity condition holds, the return on the two bonds should be (Click to select) equal different . For this to happen, given the interest rates on the two bonds, the holder of the Canadian bond must (Click to select) gain lose from the movement in the exchange rate over the year.

Answer 1

With a 10 percent interest on a U.S. bond and 8 percent on a Canadian bond, the U.S. dollar is expected to depreciate if the interest-rate parity condition holds, to equalize the returns accounting for the exchange rate.

Step-by-step explanation:

If the interest-rate parity condition holds and the interest rate on a one-year U.S. bond were 10 percent while the interest rate on an equivalent Canadian bond were 8 percent, we would expect the U.S. dollar to depreciate relative to the Canadian dollar over the next year. This is because the Canadian bond must yield the same effective return as the U.S. bond when considering the exchange rate changes. Therefore, for the return on the two bonds to be equal, the holder of the Canadian bond must gain from the movement in the exchange rate over the year to compensate for the lower interest rate.