Forces of Covered Interest Arbitrage
Response to the following problem:
Assume that the one-year interest rate in Canada is 4 percent. The one-year U.S. interest rate is 8 percent. The spot rate of the Canadian dollar (C$) is $.94. The forward rate of the Canadian dollar is $.98
a. Is covered interest arbitrage feasible for U.S. investors? Show the results if a U.S. firm engages in covered interest arbitrage to support your answer.
b. Assume that the spot rate and interest rates remain unchanged as coverage interest arbitrage is attempted by U.S. investors. Do you think the forward rate of the Canadian dollar will be affected? If so, state whether it will increase or decrease, and explain why.