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The European Monetary Authority is considering issuing a new 3-month bond denominated in "Euros" which will pay a 3% annual interest rate. The current issue of 3-month Canada Savings Bonds pays 3.6% annually.
a) If the current exchange rate is 1.2 Canadian Dollars per Euro and the 3-month forward exchange rate is 1.25 Canadian Dollars per Euro, should a resident of Canada invest in the Canada Savings Bond or in the Euro-bond?
b) Assuming that the new Euro-bond is issued with a 3% annual interest rate, in which direction would you expect Canadian interest rates and the Canadian Dollar-Euro spot exchange rate to change?
c) Again, assuming that the new Euro-bond is issued with the 3% annual interest rate, what value for the Canadian interest rate would be consistent with a zero Covered Interest Arbitrage Margin?
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