Problem: Consider a 1-year riskless Canadian bond and a 1-year riskless Japanese bonds. The interest rates on the Canadian bond and the Japanese bond are denoted by iCADt and iYent, respectively. The current spot rate is EYen/CADt, and the forward rate is FYen/CADt. The investors’ expected spot rate in 1 year is Ee Yen/CADt+1. Assume that there are no arbitrage costs.
(a) Illustrate how to derive the covered interest rate parity condition.
(b) Explain what a foreign exchange risk premium in the forward market is. Why does it exist?
(c) Show how to calculate the foreign exchange risk premium on CAD dollar.
(d) Show how the forward premium can be equal to the expected inflation differential between two countries. What assumptions are needed for this to be true?