Question

2. The nominal interest rate in the U.S. is 6% and the nominal interest rate in Canada is 3%. The spot value of the U.S. dollar is 1.1 ($/Canadian dollar) and the forward rate is 1.3 ($/Canadian dollar). Calculate the forward discount or premium for the dollar. Does the interest parity condition hold? If not explain what is likely to occur in foreign exchange markets. Assume that interest rates cannot change.

Answer 1

The forward discount is 1.0688679245. Interest parity does not hold. In foreign markets Dollar will not appreciate in spot because it is trading at forward discount

Step-by-step explanation:

According to the given data we have the following:

1 USD = 1.1 Canadian dollar (Spot)

1 USD = 1.3 Canadian dollar (Forward)

In order to calculate forward discount we would have to use the following formula:

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

Forward = 1.1*(1+0.03) / (1+0.06) = 1.0688679245

1.0688679245 < 1.2 (Interest parity does not hold)

Here dollar is trading at forward discount

In foreign markets Dollar will not appreciate in spot because it is trading at forward discount