Problem 4 . The 12-month interest rate on dollar-denominated assets (like bank d

Question

Problem 4. The 12-month interest rate on dollar-denominated assets (like bank deposits) is 2.00%. The 12-month interest rate on euro-denominated assets is 1.80%. The current spot exchange rate is $1.50 per €. The current forward exchange rate is $1.58 per €. You have an initial dollar fund of $100,000.

Suppose that you have decided today to invest your dollar fund in euro-denominated assets while also using the forward exchange market to hedge the exchange risk.

1) Explain what you should do today on the foreign exchange markets.

2) Explain what you should do 12 months from now on the foreign exchange markets.

3) Compute your investment gain in euros. What is the euro rate of return on your euro deposits?

4) Compute your investment gain in dollars. What is the dollar rate of return on your euro deposits?

5) Is your investment decision consistent with the covered interest parity based on the full formula? Show your calculations to support your answer.

6) Is your investment decision consistent with the covered interest parity based on the approximating formula? Show your calculations to support your answer.

Explanation / Answer

1) Since you have decided to invest in the Euro denominated market, First convert your $100,00 into Euros.

So Euro you have = 100,000 * 1.5 = 150,000

Also to hedge the exchange rate risk, enter into a forward contract to sell Euro's at $1.58/Euro

Invest 150,000 Euro's into Euro denominated market as decided.

2) After 12 months, your investment of 150,000 Euro will increase by 1.8%

So value at the end of year 1 would be 150,000 * (1+1.8%) = 152,700

3) Investment gain in Euro's = (152700 - 150000) / 150000 = 1.8%

4) For getting investment gain in Dollar's, we have to first convert the euro's into dollars.

Since we have entered into a forward contract, we can convert using $1.58 per euro rate.

So dollar value would be =152700 / 1.58 = 96645.57

Investment gain in dollar = (96645.57 - 100000) / 100000 = loss of 3.4%

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