Dollar Return on Foreign Investments - (A) Over the past year, the dollar has ap

Question

Dollar Return on Foreign Investments -

(A) Over the past year, the dollar has appreciated by about 8 percent against the peso. A year ago you borrowed in the U.S. at an interest rate of 4 percent and you invested the money in a Mexican mutual fund that paid a 12 percent peso return. What net return did you earn on all of these transactions over the year? (PLEASE INCLUDE FORMULAS USED TO SOLVE PROBLEM).

Inflation and Exchange Rates -

(B) 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

Answer A)

appreciated by about 8 percent against the peso. A year ago you borrowed in the U.S. at an interest rate of 4 percent and you invested the money in a Mexican mutual fund that paid a 12 percent peso return.

The profit in investment ( the difference in interest rate in two currency (peso - us$)) = 12-4 = 8%

Appreciation in currency = 8%

Net gain in transaction = difference in interest rate - Appreciation in currency

= 8% - 8% = 0 %

Answer b)

Change In exchange rate = Difference in inflation rate = 4-2 = 2% , change in $/Euro exchange = reduce by 2%

dollar return on a European bond for this year = return in Euro bond - change in exchange rate= 6-2 = 4% .

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