7. Consider a Dutch investor with 1,000 euros to place in a bank deposit in eith

Question

7. Consider a Dutch investor with 1,000 euros to place in a bank deposit in either the Netherlands or Great Britain, The (one-year) interest rate on bank deposits is 2% in Britain and 4.04% in the Netherlands. The (one-year) forward euro-pound exchange rate is 1.575 euros per pound and the spot rate is 1.5 euros per pound. Answer the following questions, using the exact equations for UIP and CIP as necessary (a) What is the euro-denominated return on Dutch deposits for this investor? (b) What is the (riskless) euro-denominated return on British deposits for this investor using forward cover? (c) Is there an arbitrage opportunity here? Explain why or why not. Is this an equilibrium in the forward exchange rate market? (d) What is the equilibrium forward rate, according to covered interest parity (CIP)? (e) Suppose the forward rate takes the value given by your answer to (d). Compute the forward premium on the British pound for the Dutch investor (where exchange rates are in euros per pound). Is it positive or negative? Why do investors require this premium/discount in equilibrium? (f) If uncovered interest parity (UIP) holds, what is the expected euro-pound exchange rate one year ahead? 8. You are a financial adviser to a US corporation that expects to receive a payment of 40 million Japanese yen in 180 days for goods exported to Japan. The current spot rate is 100 yen per US dollar(Es 0.01). You are concerned that the US dollar is going to appreciate against the yen over the next six months. (a) Assuming the exchange rate remains unchanged, how much does your firm expect to receive in US dollars after six months? (b) CalculateEs when the dollar appreciated to 110 yen per US dollar? (c) How much would your firm receive(in US dollar) if the dollar appreciated to 110 yen per US dollar after six months? (d) Describe how you could use an options contract to hedge against the risk of losses associated with the potential appreciation in the US dollar

Explanation / Answer

Answer

a)

Return on Dutch deposit is 1000 + (4.04/100)*1000 = 1040.4

b)

Return on British deposit is [1000/1.5 + (2/100)*(1000/1.5)] * 1.575 = (1020*1.575) / 1.5 = 1071 Euros

c)

Forward exchange rate = 1.5 * [(1 +4.04)/(1 + 2)] = 2.52

But Forward exchange rate given is 1.575

Hence Arbitrage is possible and it is not the equilibrium in the foreign exchange market.

d)

Equilibrium Foreign Rate according to CIP is 2.52 as calculated above.

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