The following exchange rates exist on a particular day.
The following (annualized) interest rates on 90-day government bonds also exist on this day:
a. The spot (current) exchange rate is US
$1.400/euro
Investors expect the spot rate to be 0.7100 euro/US dollar in 90
days.
0.7100 euro/US dollar is equivalent to 1/0.7100 = USD 1.4084
euro.
Therefore, the investors are expecting that the euro will
appreciate against the dollar in next 90 days.
b. Suppose an investor has $1 to invest. Assume
there is no compounding on the interest.
An investment of $1 in the USD-denominated bond with 16% interest
rate will have the future value of $1.16 in 90
days.
If the investor exchanges his dollar to euro today at
$1.400/euro (spot rate), it will be equal to 0.7143 euros.
An investment of 0.7143 euros in the euro-denominated bond with 8%
interest rate will have the future value of 0.7714 euros in 90
days.
The 90-days forward exchange rate is $1.427/euro. Therefore, 0.7714
euros will be equivalent to $1.1
Therefore, the direction of the uncovered investment would be towards the United States as it fetches a higher return on a dollar investment than it does in the euro area.
The following exchange rates exist on a particular day. Spot exchange rate: U.S. $1.400/euro Forward exchange...
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