Problem Set 20 2-1

Finance Problem Set 20 2-1

1. The covered interest parity condition substitutes the forward exchange rate for the expected exchange rate. The condition is labeled covered because the forward contract assures a certain rate of return (i.e. without risk) on foreign deposits. In the Table below is listed a spot exchange rate, a 90-day forward rate, and a 90-day money market interest rate in Germany and Canada. Use this info to answer the following questions.

Germany Canada

Spot ER .5841 $/DM .7451 $/C$

90-day For-ER .5807 $/DM .7446 $/C$

90-day Interest Rate 1.442% .875%

A. What would the US 90-day interest rate have to be for the US to have the highest rate of return for a US investor? (Use the exact formulae to calculate the rates of return.)
B. If spot exchange rates move until covered-interest parity holds exactly, then would you expect the Canadian dollar to appreciate or depreciate with respect to the DM on the next day of trading? Explain why.