4. Interest Rate Parity

a. Discuss the interest rate parity and illustrate it in graph using U.S. (home) and Canadian (foreign) interest rates. Choose one point on the line, one point below the line, and one point above the line to discuss specific examples. For each point discuss which country's investors will invest in the other country and what market forces these actions will cause to bring rates back to parity.

b. Assume the following information:

Spot rate of Canadian dollar = $0.80; 1 year the U.S. interest rate= 7% and 1-year Canadian interest rate = 4%. According to the IRP what should the 1-year forward rate of Canadian dollar be?

Is there an arbitrage opportunity if 1-year forward rate of Canadian Dollar currently is $0.75? What form of arbitrage is it and will American investors invest in Canada or Canadian investors invest in the U.S.?