Assume the current spot rate is C$1.2568 and the one-year forward rate is C$1.2455. Also assume the nominal risk-free rate in Canada is 3.7 percent compared to 4.1 percent in the U. S. Using covered interest arbitrage, how much additional profit can you earn over that which you would earn if you invested $1 in the U. S for one year?

A) $.0054B) $.0042C) $.0008D) $.0015E) $.0061

option (A) $0.0054

Explanation:

Data provided in the question:

Current spot rate = C$1.2568

One-year forward rate = C$1.2455

Nominal risk-free rate in Canada = 3.7% = 0.037

Nominal risk-free rate in U. S = 4.1% = 0.041

Now,

Value of $1 invested in C$ = 1 * Spot rate

= 1 * 1.2568

= C$1.2455

After 1 year the value of amount invested using nominal risk-free rate in Canada

= 1.2568 * (1 + 0.037)

or

Final value of investment = C$1.3033016

Now,

Converting Final amount of investment back into $

= (Final value of investment) : (one-year forward rate)

= 1.3033016 : 1.2455

= $1.0464

Value of amount invested in $ after 1 year using Nominal risk-free rate in U. S

= $1 * (1 + 0.041)

= $1.041

Additional profit

= Final amount in $ after 1 year - Value of Amount invested

= $1.0464 - $1.041

= $0.0054

Hence,

The answer is option (A) $0.0054