1. Use the asset approach to exchange rate determination discussed in class to answer the following questions. The interest rate on euro denominated assets maturing in one year is 11% and the interest rate on comparable Canadian dollar denominated assets is 6%.

I. Consider two possible expectations for the direct spot exchange rate between the Canadian dollar and the euro (Canadian dollars per euro) in one year: (1) the spot rate will fall by 10 Canadian cents or (2) the spot rate will rise by 6 Canadian cents (note that these changes are in absolute levels, not in percentage terms). Determine the current equilibrium spot rate under each scenario. Explain which expectation for the future spot rate makes sense, justify your answer, and provide economic intuition for your result.

II. Using the expectation scenario from part (I) that makes sense, determine the equilibrium spot rate when the European interest rate decreases to 10%. Determine whether the Canadian dollar appreciated or depreciated in response to this change and provide economic intuition for your finding. Show the initial and new equilibrium current spot rates in a diagram.

III. Suppose, instead, that the spot rate is expected to decrease by a percent over the next year. Explain whether or not you can determine the equilibrium spot rate in this scenario and justify your answer. Determine the value of a which is consistent with our model.

IV. Suppose interest rates are as given initially (11% in Europe and 6% in Canada) and the current spot rate equals 2.25 Canadian dollars per euro. Calculate the forward discount or forward premium.