An investor based in the United States wishes to invest in Canadian bonds with a maturity of one year. Suppose that the ratio of the price levels of a typical consumption basket in the United States versus Canada is 1 to 1.2 and the current exchange rate is $0.85 per Canadian dollar. The one-year interest rate is 1 percent in the United States and 3.6 percent in Canada. Assume that inflation rates are fully predictable, and expected inflation over the next year is 2.5 percent in the United States and 6 percent in Canada.

a) Calculate the real (effective) exchange rate.

b) Assuming that real exchange rates remain constant, calculate the expected exchange rate in one year, and the expected return over one year on the Canadian bond in U.S. dollar terms.

c) Now assume that the inflation rate over the one-year period has been 1.0 percent in the United States and 5 percent in Canad Further, assume that the exchange rate at the end of one year is $0.89 per Canadian dollar. Calculate the real exchange rate at the end of one year. What is the return on the Canadian bond investment now?