Question

B. Consider the following prices for government bonds and foreign exchange in Canada and the United States. Assume that both government securities are one-year bonds, paying the face value of the bond one year from now. The exchange rate, El, stands at US$1.00 = C$1.33. The face values and prices on the two bonds are given by: Face Value P rice Canada C$1000.00 C$943.3962 United States US$1000.00 US$961.5384 1. Compute the nominal interest rate on each of the bonds. 2. Compute the expected next year exchange rate that is consistent with uncovered in- terest parity. 3. Your friend expects the exchange rate next year to be US$1.00 = C$1.40. Which bond should your friend buy? Why? 4. You expect the exchange rate next year to be US$1.00 = C$1.30. Which bond should you buy? Why?

Answer 1

1. Nominal Interest Rate = ((Face Value - Purchase Price)/ Purchase Price )* 100

Canada = ((1000-943.3962)/943.3962 ) * 100 = (56.6038/943.3962) *100 = 6%

United States = (1000-961.5384)/961.5384 ) * 100 = (38.4616/961.5384) *100 = 4%

2. Current Exchange rate $1 = C$1.33,

Future Exchange rate = (1+id​)=F/S​ ∗(1+if​)

where:

id​=The interest rate in the domestic currency or the base currency = 6%

if=The interest rate in the foreign currency or the quoted currency = 4%

S=The current spot exchange rate = $1 / C$ 1.33 = $ 0.7519

F=The forward foreign exchange rate​ = ?

1.06 = 0.7519/ F * 1.04

1.06/1.04 = 0.7519/F

1.0192 =  0.7519/F = F = 0.7519/ 1.0192 = $ 0.7377

1 C$ = $ 0.7377

Next Year Exchange rate 1$ = 1/0.7377 = C$1.3555.

3. If expect $1 = C$ 1.40, current Exchange rate $1= C$1.33, means Dollar is getting stronger. Better to Invest in United States government Bond.  

4. If expect $1 = C$1.30, current Exchange rate $1= C$1.33, means Dollar is getting weaker. Better to Invest in Canadian government Bond.