Question

The nominal interest rate in the U.S. is 5% and the nominal interest rate in Canada is 3%. The spot value of the U.S. dollar is 1 ($/Canadian dollar) and the forward rate is 1.2 ($/Canadian dollar). Which of the following is not true?A. The interest parity condition does not hold.

B. The dollar is likely to appreciate in spot markets.
C. Money will flow into the Canada.
D. The dollar is trading at a forward discount.

Answer 1

Answer: B. The dollar is likely to appreciate in spot markets.

Step-by-step explanation:

First find the forward rate using the forward rate formula:

Forward rate = Spot rate * (1 + Interest rate of Canada) / (1 + Interest rate of US)

= 1 * ( 1 + 3%) / (1 + 5%)

= 0.980952

= 0.98

The forward rate according to the formula is less than the forward rate that is trading.

This means that the U.S. dollar is trading at a forward discount and when this happens, the dollar will not appreciate in the spot markets because it is scheduled to be discounted in the forward market.