Question

Assume the interest rate in Britain is 9%, the interest rate in Canada is 6%, Rt=2.7, and Rt+1=3. Calculate the return in Canadian $ of investing in Britain for 1 year. In addition, show whether the interest rate parity condition holds. Finally, what will be the effects on the balance of payments and the exchange rate? Rt= current exchange rate. Rt+1= future exchange rate

Answer 1

Answer;

It means than at present, 1 Canada Dollar = 2.7 British Pound and 1 year later, it is 3 British Pound.

Suppose one invests 100 Canada Dollar into British market, so he get 270 British Pound, after an year, it becomes 270x1.09=294.3 British Pound which becomes 294.3/3=98.1 Canadian Dollar.

Thus, the total return is -1.9%

The exchange rate will fall as a result and more investment will flow from Britain to Canada due to higher exchange rate.