Problem 4. (50 Points) The 12-month interest rate on dollar-denominated assets (

Question

Problem 4. (50 Points) The 12-month interest rate on dollar-denominated assets (like bank deposits) is 5.00%. The 12-month interest rate on euro-denominated assets is 2.50%. The current spot exchange rate is $1.20 per €. The current forward exchange rate is $1.00 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. (10 pts)

2) Explain what you should do 12 months from now on the foreign exchange markets. (10 pts)

3) Compute your investment gain in euros. What is the euro rate of return on your euro deposits? (10 pts)

4) Compute your investment gain in dollars. What is the dollar rate of return on your euro deposits? (10 pts)

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

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

Explanation / Answer

Dollar Interest Rate = 5%

Euro Interest Rate = 2.50%

Spot Rate per Euro = $1.20

Forward Rate per Euro = $1.00

Initial Fund = $100,000

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

Sell the dollar at spot rate to convert into Euro.

Amount in Euro = 100,000/1.2 = 83333.33

Invest in Euro @2.5% thereby getting 83333.33*(1+0.025) = 85416.67 at end of one year

Book a forward contract to convert Euro into dollar at end of one year

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

Convert euro 85416.67 into dollar at the forward rate of 1.00 thereby getting $85416.67

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

Investment Gain in Euro = 85416.67-83333.33 = 2083.34

Euro Rate of Return = 2.5%

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

Investment Gain in Dollar = 85416.67-100000 = -14,583.33

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