Suppose that you just bought a car costing US $45,000 in Detroit, payable in three months. You have enough Canadian dollars at your bank in Windsor, which pays 0.32% interest per month, compounding monthly, to pay for your car. The current spot exchange rate is CAD $1.25/USD, and the three-month forward exchange rate is CAD $1.20/USD. In the US, the money market interest rate is 2.2% for a three-month investment. There are two alternative ways of paying for your car.
(a) Keep the money at your bank in Windsor and buy US $45,000 forward.
(b) Buy a certain USD amount spot today and invest the proceeds in the US for three months, so you will have exactly US $45,000 to pay for your car. Evaluate each payment method. Which method would you prefer? Why?
