Question
The 1-year risk-free interest rate of investments in US dollars is =1.9%. The 1-year risk-free interest rate of investments in Canadian dollars is =4%. The
The 1-year risk-free interest rate of investments in US dollars is =1.9%. The 1-year risk-free interest rate of investments in Canadian dollars is =4%. The current (spot) exchange rate between the two currencies is 1.4: the price of 1 USD is 1.4 CAD. The 1-year forward price of 1 USD is 1.41 CAD. You can trade in 1-year risk-free discount bonds denominated in both US and Canadian dollars, in the forward contract to buy 1 USD 1 year from now, and in the spot foreign exchange market, where you can buy and sell USD.
Consider the following strategy:
1. Borrow USD at 1.9% today, which means that the total loan repayment obligation after a year would be (1+1.9%) USD.
2. Convert USD into CAD at the spot rate of 1.4.
3. Lock in the 4% rate on the deposit amount of 1.4 CAD, and simultaneously enter into a forward contract that converts the full maturity amount of the deposit into USD at the one-year forward rate of USD = 1.41 CAD.
4. After one year, settle the forward contract at the contracted rate of 1.41. Suppose the above arbitrage strategy generates 100 USD today and nothing otherwise, please solve for and
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