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). 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.
What will be an ideal response?
The dollar is trading at a forward discount. [(1-1.2)/1 = -0.2, or -20%]. The interest rate differential is .05-.02 = .03, or 3%. The expected depreciation of the dollar exceeds the interest rate differential, or in other words, the higher U.S. interest rate is not sufficiently attractive given that the dollar is expected to depreciate sharply. Thus funds will flow into Canada. Assuming no changes in interest rates, the Canadian dollar will appreciate and the U.S. dollar will depreciate until interest parity holds.
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