Question

The rise of globalization is due to the many companies that have become multinational corporations for various reasons-for example, to access better technology, to enter new markets, to obtain more raw materials, to find funding resources, to minimize production costs, or to diversify business risk. This multimarket presence exposes companies to different kinds of risk as well-for example, political risk and exchange rate risk. The relationship between interest rates and exchange rates can be represented through the concept of interest rate parity. Consider the following: Suppose you observe the following spot and forward exchange rates between the U.S. dollar ($) and the Canadian dollar (C$): 1) The current one-year interest rate on U.S. Treasury securities is 8.03%. If interest rate parity holds, what is the expected yield on one-year Canadian securities of equal risk?

Answer 1

The formula for calculating the expected yield takes into account the current spot and forward exchange rates between the U.S. dollar and the Canadian dollar and the U.S. interest rate. In this case, if the U.S. interest rate is 8.03% and the spot exchange rate is $1 = C$1, with a forward exchange rate of $1 = C$1.10, the expected yield on one-year Canadian securities would be 7.30%.

Step-by-step explanation:

The expected yield on one-year Canadian securities of equal risk can be determined using the concept of interest rate parity. According to interest rate parity, if interest rate parity holds, the expected yield on one-year Canadian securities can be calculated by adjusting the U.S. interest rate based on the current spot and forward exchange rates between the U.S. dollar and the Canadian dollar.

Let's assume that the spot exchange rate between the U.S. dollar and the Canadian dollar is $1 = C$1. The forward exchange rate is the expected future exchange rate between the two currencies. If the forward exchange rate is $1 = C$1.10, it means that the Canadian dollar is expected to appreciate in the future.

To calculate the expected yield on one-year Canadian securities, we can use the formula:

Expected Yield on Canadian securities = (U.S. interest rate / Forward exchange rate) x Spot exchange rate

Using the given information, if the current one-year interest rate on U.S. Treasury securities is 8.03%, and the spot exchange rate is $1 = C$1, and the forward exchange rate is $1 = C$1.10, the expected yield on one-year Canadian securities would be:

(8.03% / 1.10) x 1 = 7.30%

Therefore, the expected yield on one-year Canadian securities of equal risk is 7.30%.

Answer 2

The expected yield on one-year Canadian securities is determined based on the interest rate parity concept. It must compensate for currency exchange expectations due to differences in U.S. and Canadian interest rates.

Step-by-step explanation:

The question asks for the expected yield on one-year Canadian securities of equal risk if the interest rate parity holds, given the current one-year interest rate on U.S. Treasury securities is 8.03%. Interest rate parity is a financial theory which posits that the difference in interest rates between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. This concept plays a crucial role in exchange rates and interest rates. When interest rates increase in a country relative to others, like the United States relative to Mexico, it tends to increase demand for that country's currency, causing it to appreciate. In contrast, a country with lower interest rates will see its currency depreciate. Thus, if U.S. rates are higher than in Canada, we would expect a stronger U.S. dollar relative to the Canadian dollar in the future. The expected yield on Canadian securities would, therefore, need to be higher than the U.S. rate to compensate investors for the anticipated depreciation of the Canadian dollar.