Suppose the following facts apply: Spot currency rate ($/ = $1.28); Forward exch
ID: 2723170 • Letter: S
Question
Suppose the following facts apply: Spot currency rate ($/ = $1.28); Forward exchange rate for 1 year delivery = $1.25; US 1-year interest rate: rUS = 4%; Euro 1-year interest rate: rE = 7%; Amount to invest = $5,000,000. You reside in the United States but wish to invest your $5 million in the 1-year European bonds. In order to execute a covered interest arbitrage, you sell 1-year euro futures. What is your rate of return on your overseas investments - after converting your investment proceeds back to USD?
4.045%
4.492%
7.125%
None of the above
Explanation / Answer
Dollar value of investment = $5,000,000
Spot exchange rate = $1.28
Value of investment in EURO = $5,000,000 / $1.28
= 3,906,250 euro
Total Euro of investment = 3,906,250 euro
Interest rate in Europe = 7%
Value of investment after one year = 3,906,250 × (1 + 7%)
= 4,179,687.50
Forward exchange rate = $1.25
Value of investment after one year in term of Dollar = 4,179,687.50 × $1.25
= $5,224,609.375
Total Return = ($5,224,609.375 / $5,000,000) – 1
= 1.04492 -1
= 4.492%
Total return from Investment is 4.492%
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