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?
