Using Spot and Forward Exchange Rates. Suppose the spot exchange rate
for the Canadian dollar is Can$1.20 and the six-month forward rate is
Can$1.23.
a. Which is worth more, a U.S. dollar or a Canadian dollar?
b. Assuming absolute PPP holds, what is the cost in the United States
of an Elkhead beer if the price in Canada is Can$3.10?Why might the
beer actually sell at a different price in the United States?
c. Is the U.S. dollar selling at a premium or a discount relative to
the Canadian dollar?
d. Which currency is expected to appreciate in value?
e. Which country do you think has higher interest rates ?the United
States or Canada? Explain.

Hi tangothecat

Here's a freebie answer for you.

a> $1 = C$1.2 so US is worth more

b> Purchasing Power Parity implies consumers can buy the same goods
irrespective of currency (it's sometimes illustrated by the Big Mac
index..ie the price of a Big Mac in diferent currencies reflects the
long term equilibrium relationship between those currencies). So
C$3.1/1.2 or US$2.58 is the implied PPP price. But this is a
theoretical equivalence - the fact that (presumably) Elkhead beer is
brewed in Canada implies a comparative advantage for Canadian
consumers. Transportation costs would increase the price in the US. In
practice there are many other factors eg different size of market,
competitive conditions that also would need to be taken into account.

c> US dollars are trading at a premium to Canadian dollars in the
forward market. In other words it takes more Can$ (1.23) to buy US$1.

d> Although the Can$ is trading at a discount in the forward FX market
this does not imply that the US$ is expected to appreciate in value.

All future expectations about the relative strength/weakness of US$
versus C$ are in fact contained within the current spot rate. To
understand why this is consider an alternative way of paying out Can$
and receiving US$ in 6 months.

If I want to sell C$ in 6 months there are two basic ways to do it. I
can either use the forward market or by selling C$ / buying US$ in the
spot market and simultaneously borrowing C$ and lending US$ in the
equivalent amounts for the 6 month period. I'm left with net cashflows
of zero on the spot date and an outflow of C$/inflow of US$ in 6
months time. The actual amouts will depend on how much interest I have
to pay and receive in each of the two currencies. The implied FX rate
is merely the Can$ amount divided by the US$ amount.

The fact that this alternative exists means that if the forward FX
rate did not reflect the interest rate differential between the two
currencies arbitrage would be possible. People would do equal and
opposite transactions two lock in profit by eg selling Can$/ buying
US$ spot and simultaneously borrowing Can$ and lending US$ for 6
months on the one hand, which would create  a - Can$/+US$ position in
6 months time. At the same time they would use the forward FX (or
indeed the currency futures market) to buy Can$ and sell US$ in 6
months. As the arbitrage is spotted and acted on the price
differential is eliminated by supply and demand pressures. Because
this arbitrage is already widely understood it is automatically
incorporated into the way forward FX is priced.

e> See <d> for a fuller explanation, but the answer here is that
Canada has higher interest rates. The actual interest differential is
a time value of money calculation. To find the precise mathematical
differential you need to know one or other country's 6 month interest
rate, but you can get a good approximation via the following
formula...( Fwd/Spot - 1) / n , where n is the number of years. So in
this case:-

(1.23/1.20 - 1)/0.5 
= 5%

So Can$ 6m interest rates are (approximately) 5% higher than US$ 6m interest rates
  
Good luck with your studies

Thank you so much...your explaination was very helpful....