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IRP, PPP, and Speculating in Currency Derivatives

34. The U.S. three-month interest rate (unannualized) is 1%. The Canadian three-month interest rate (unannualized) is 4%. Interest rate parity exists. The expected inflation over this period is 5% in the U.S. and 2% in Canada. A call option with a three-month expiration date on Canadian dollars is available for a premium of $.02 and a strike price of $.64. The spot rate of the Canadian dollar is $.65. Assume that you believe in purchasing power parity.

a. Determine the dollar amount of your profit or loss from buying a call option contract
specifying C$100,000.

b. Determine the dollar amount of your profit or loss from buying a futures contract
specifying C$100,000.

Solution Preview

a. Determine the dollar amount of your profit or loss from buying a call option contract
specifying C$100,000.

The expected change in the Canadian dollar's spot rate is:

(1.05)/(1.02) - 1 = 2.94%.

Therefore, the ...

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