ECONOMICS

2. Suppose a Canadian agent (investor) with C$1.0 million is choosing between bank deposits denominated in either euro or Canadian dollars. Also suppose that the (one-year) interest rate paid on the C$ deposits is 1% (0.01) and on the euro deposit is 2% (0.02), the (one-year) forward C$-EURO exchange rate (FC$/€ ) is 1.60 and the current spot rate (EC$/€ ) is 1.65. Based on this information, answer the following questions.

(a) What is the forward spread? Is the Canadian dollar at forward premium or discount? And by how much (%)?

(b) What is the (hedged = riskless) rate of return on the euro deposits?

(c) Based on your answer above, is there an arbitrage opportunity between the two deposits? Explain why or why not.

(d) If the spot rate of exchange as well as the interest rates are kept at their current levels (stated above), what will be equilibrium forward rate as implied by the covered interest parity theory (CIP)?