(hypothetical) The current exchange rate between the US dollar and the Euro is $

Question

(hypothetical) The current exchange rate between the US dollar and the Euro is $2.2500/1Euro.  The interest rate on a 52 week US Treasury bill has recently increased to 4.5%.  By contrast, the interest rate on a risk-free 52-week Euro denominated money market security is 1.5%.  Your management firm is evaluating whether to invest in dollar-denominated T-bills or risk-free Euro denominated money market securities.  Assuming that the forward rate for the exchange of Euros and Dollars at the end of 1 year is (Euro)0.4327/$1. Determine whether you should invest in risk-free dollar-denominated T-Bills or risk-free Euro denominated money market securities.

Explanation / Answer

Spot rate = 1/2.25 = EUR 0.4444/1$

Given the information and according to the interest rate parity formula, the USD interest rate should be = 0.4444*(1+1.5%)/0.4327 -1 = 4.25%

However the USD interest rate is actually 4.5%. So we should invest in risk-free dollar-denominated T-Bills given the higher interest rates.

Hope this helped ! Let me know in case of any queries.

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