Problem
A Canadian investor is considering investing in bank deposits in Canada and France. The spot exchange rate is 1.53 CAD/€. The annual interest rate on Canadian deposits is 3.5%, and the annual interest rate in France is 3.75%. The forward rate is equal to ??CAD/€ = ??. ???? and the expected exchange rate is 1.5 CAD/€. Use the exact equations for uncovered and covered interest rate parity to answer the following questions.
1) Does covered interest parity hold in this case? Explain why or why not.
2) Does uncovered interest parity hold in this case? Explain why or why not.
3) Assume the exchange rate one year after is 1.48 CAD/€. Calculate the Canadian investor's actual return after one year. Did he earn a positive return?
4) Compare the returns of two Canadian investors: one using hedging, and one using speculation. Which one is financially better off after the one-year period?