Question 3 a) Suppose the current return on Canadian (domestic) bonds is 7% and the return on European bonds is 4%. If the current spot price of one Euro is 1.3 Canadian dollars what would be the future expected exchange rate according to the interest parity? Is the Canadian dollar expected to appreciate or depreciate? b) If the forward rate (or expected future exchange rate) is actually 1.32 Canadian dollars per Euro, what would be your arbitrage strategy? How much profit would be earned on a \$5000 investment? c) If the inflation rate in Europe is 8%, what would be your real interest from part B if you had invested in Europe?
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The formula for interest parity is: (1 + r_foreign) = (1 + r_domestic) * (Ee / Es) Where: r_foreign = return on European bonds = 4% r_domestic = return on Canadian bonds = 7% Ee = expected future exchange rate Es = current spot exchange rate = 1.3 Canadian Show more…
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