Dollar Return on Foreign Investments - (A) You can borrow or invest in the U.S.

Question

Dollar Return on Foreign Investments -

(A) You can borrow or invest in the U.S. at an annual rate of 6 percent. Suppose you logon to your favorite financial website and see that you could borrow or invest in Japan at a 5 percent annual rate. The current exchange rate between the dollar and the yen is $0.01/yen. You can use the futures market to lock it in at an exchange rate for one year from now at $0.0095/yen. Is there a profit opportunity here? Prove it by borrowing (either $1 million or $100 yen) in one country and investing in the other? (PLEASE INCLUDE FORMULAS USED TO SOLVE PROBLEM).

Inflation and Exchange Rates -

(B) Suppose gold sells for $1,000 per ounce in the U.S. and it sells for 1,000 Canadian dollars per ounce in Canada. Suppose further, the exchange rate is $1 per Canadian dollar. If U.S. inflation is 6 percent next year, Canadian inflation is 2 percent, and exchange rates do not change, how could you make an arbitrage profit in the gold market? (PLEASE INCLUDE FORMULAS USED TO SOLVE PROBLEM).

(C) Suppose U.S. interest rates on a risk-free, one-year bond are 4 percent and European interest rates on a risk-free, one-year bond are 6 percent. Suppose further than inflation is 2 percent in the U.S. and 4 percent in Europe. Assume it takes one year for the exchange rate to adjust to inflation differences. What is the predicted change in the $/euro exchange rate for the next year? Given that, what would the dollar return on a European bond be for this year? (PLEASE INCLUDE FORMULAS USED TO SOLVE PROBLEM).

Explanation / Answer

a) There is an arbritage opporunity if one borrows money from Japan and Invests in US, the following workings will give us profit of 6.58Yen

6.578947368

b)

In Gold market we can make arbirtage profit of $60 canadian dollar if we purchase in canada and sell in US market

c) Based on the above information, US's real interest rate is 2%(4%-2%) assuming the arbitrage will equal the real interest rates in Europe, Europe's interest rate will be 6%(4%+2%), since the interest rate in Europe is 6% there would be no change in the $/euro exchange rate

Suppose I borrow 100 yen from Japan I would get (100*0.01) 1 I can invest $1 in US, after one year I would have (1*1.06) 1.06 Yen I would receive = 1.06/0.0095 111.5789474 Loan amount to be paid(100*1.05) 105 Net Profit/Loss

6.578947368

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