$[$INTEREST RATE PARITY$](10$ marks$)$

An investor wants to purchase a $$10,000$ financial asset and hold it for one year.

Suppose she has limited her choice to either Canadian government bond or US

government bonds. Canadian government bonds are denominated in Canadian

dollar $($CAD$)$ and pay a nominal interest rate of $i=8\%$ for one year. US gov$-$

ernment bonds, which are denominated in USD, pay a nominal interest rate of

$i^{**}=6\%$ for one year. The two financial asset have comparable liquidity and risk

default, we ignore transaction costs and difference in how interest income might be

taxed should it be earned at home versus abroad. In addition, we assume that the

current value of the nominal exchange rate $0\mathrm{.}7$ USD per CAD, $e_{\text{n}\text{o}\text{m}}=0\mathrm{.}7,$ and that

the exchange rate is expected to depreciate by $3\%$ over the coming year, meaning

that the expected future value of the exchange rate $e_{\text{n}\text{o}\text{m}}^f=0\mathrm{.}679$

$($a$)(2$ marks$)$ What is the gross financial return on Canadian government bonds?

$($b$)(3$ marks$)$ What is the gross financial return on US government bonds? $($Hint:

Recall that you need $3$ steps in your calculations$)$

$($c$)(2$ marks$)$ Which asset would you recommend to this investor? Why?

$($d$)(3$ marks$)$ Define the Interest Rate Parity condition.