Suppose you are working for a Canadian investment firm, and you observe that the (annual) yield differential between Canadian assets and British assets is 0.28 percentage points, and the British assets are more attractive than the Canadian assets.

a) Suppose you call the bank for exchange rate quotes, and the quotations for the C$/ in the spot market and the forward market are 1.7500 and 1.7535 respectively. Is there any arbitrage opportunity? If yes, what would you do? If no, why? Explain. (6 points) Note: Assume your firm does not have any funds denominated in C$ and .

b) Suppose your firm has the ability to change the spot exchange rate, the forward exchange rate, and the corporate bond yields in both countries, what happens to these four variables after the transactions you carried in part (a)? Explain in words. (8 points)

c) Suppose the pandemic hits Britain harder than Canada; therefore, the market anticipates it might take longer time for Britain to cover from the pandemic.

What happens to the demand for British assets? Explain. (3 points)

Suppose the change in the demand for British assets causes the interest rate differential between Canadian assets and British assets to change by 0.08 percentage points. Which assets would you like to hold? Explain. (3 points)

Hint: You need to decide whether the interest rate differential will increase or decrease and be sure to explain why the interest rate differential increases or decreases.

Note:

1) Quote the exchange rates as EC$/ and FC$/.

2) This question requires you to use covered interest rate parity.

3) Instead of the assumption made in class (individuals are small players and cannot affect the exchange rates and interest rates), the firm in this question is a LARGE player which has the ability to change the exchange rates and the corporate interest rates when it carries transactions in the spot exchange market, the forward exchange market, and corporate bonds markets in Canada and Britain.

4) Use the subscripts "C" and "B" to represent all the variables and terms used for Canada and Britain respectively in your written explanation. You must use these notations; otherwise, you will receive a grade of ZERO for the whole question on the exam.

5) DO NOT assign any actual values to the interest rates on the Canadian and British assets. If you do so, you will receive a grade of ZERO for the whole question on the exam.