Since money flows "costlessly" you want to examine the no arbitrage scenario...
Perhaps this is best explained by an example. One US dollar buys C$1.25. So 1 C$ buys = 1/1.25 = US$0.80 You borrow $100 US. You convert $100 US into Canadian, buying C$125. We'll use a one year time frame for simplicity's sake.
You invest that C$ and earn 5%. In one year you will have C$125(1.05) = C$131.25
In one year you will owe $1(1.01) = $101 on your US loan.
Now you want to sell your C$131.25 and buy dollars to pay off the loan.
In order for there to be no arbitrage, the C$131.25 must = US$101.00
so the future spot rate must be: 131.25 / 101 = 1.2995 <$1 US buys C$1.2995
or conversely, 1/1.2995 = 0.76952
so you take your C$131.25 and buy USD...C$131.25 * 0.76952 = $101
Notice that in the future $1US buys MORE Canadian...
from US$1 buys C$1.25 current spot rate
to: US$1 buys C$1.2995 future spot rate
so the dollar is strengthening
the lower interest rate currency strengthens against the higher interest rate currency
So, the answer is c, but I'm afraid I didn't explain it very well.
25. ___ Imagine that the US dollar is expected to appreciate 2% relative to the Canadian
dollar over the next year, and capital can flow costlessly between Canada and the
US. If the interest rate on 1-year US Treasury bills is 1% and the interest rate on
perfectly substitutable Canadian Treasury bonds is 5%, we would anticipate
(a) excess demand for US$-denominated assets, which would force the value of the
US$ down;
(b) excess supply for US$-denominated assets, which would the value of the US$
down;
(c) excess supply for US$-denominated assets, which would force the value of the
US$ up;
(d) excess demand for US$-denominated assets, which would force the value of the
US$ up.
WHY IS THE CORRECT ANSWER B) ????
