Beth Miller does not believe that the international Fisher effect (IFE) holds. C

Question

Beth Miller does not believe that the international Fisher effect (IFE) holds. Current 1-year interest rates in Europe are 5 percent, while 1-year interest rates in the United States are 3 percent. Beth converts $100,000 to euros and invests them in Germany. One year later, she converts the euros back to dollars. The current spot rate of the euro is $1.10.

a. According to the IFE, what should the spot rate of the euro in 1 year be?

b. If the spot rate of the euro in 1 year is $1.00, what is Beth's percentage return from her strategy?

c. If the spot rate of the euro in 1 year is $1.08, what is Beth's percentage return from her strategy?

d. What must the spot rate of the euro be in 1 year for Beth's strategy to be successful?

Explanation / Answer

a) The current spot rate is $1.1/ Euro

forward rate would be = 1.1*(1+.03)/(1.05)

=1.079

b) First convert 100,000dollars into euro therefore

1 euro = $1.1

100,000/1.1 = Euro 90909.09

Hence he would get back 90909.09*(1.05) Dollars = 95454.55, because $1 = 1 euro

Here return would be -4.55%

3 At 1.08 he would get 95454.55*1.08 =103090.9 dollars

Here the return would be 3.09%

4) Spot rate must be atleas 100000/95454.55 =

It should be atleast 1.047 for it to be succesful

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