Question

You are in charge of managing $10 million for one year. You are allowed to invest only in the US or German government bonds, both of which are considered risk free. The money is needed exactly one year from now in dollars, and you are not allowed to take any risks with it. The interest rates on the dollar and the German bonds are, respectively, i = 0.02 and i = 0.05. The spot exchange rate is e = 0.90€/$ and the forward rate is e = 0.945€/$.

What is the highest return you can expect on the $10 million? Assume that any contract you make must be backed by the assets that you already have.

Answer 1

The maximum return it can generate is 2% which is the return on the US bond.

Although, the interest rate on the German bond is higher than the US at 5% but it will not yield any gain.
$10 million can be converted into EUR at the exchange rate of 0.9EUR/USD.
$10 million * 0.9 = EUR 9 million
The value of the investment after 1 year,
9000000 * 1.05 = EUR 9450000 or EUR 9.45 million
Conversion after 1 year at the exchange rate of 0.945EUR/USD
9450000 / 0.945 = $10 million

So the maximum return could be earned is by investing in the US bond at 2%.