Question

The 12-month interest rate on dollar-denominated assets (like bank deposits) is 2.00%. The 12- month interest rate on euro-denominated assets is 4.50%. The current spot exchange rate is $1.15 per euro. The current forward exchange rate is $1.05 per euro. You have an initial dollar fund of $100,000. Suppose that you decide to invest your dollar fund in euro-denominated assets while also using the forward exchange market to hedge against the exchange risk.

Please show work and choose A, B, C, or D.

Answer 1

Question 10

Let's convert $ 100,000 in Euro deposits. Spot rate, S = $ 1.15 / euro

Hence, quantum of euro deposits= 100,000 / S = Euro  86,956.5217

The amount a year later = Euro  86,956.5217 x ( 1 + 12 months interest rate on euro deposit assets) =  86,956.5217 x (1 + 4.5%) =  90,869.5652

Let's convert it back to $. Forward rate = F = $ 1.05 / Euro

Hence, maturity amount in $ =  90,869.5652 x F =  90,869.5652 x 1.05 = $ 95,413.0435

Hence, dollar denominated returns =  95,413.0435 / 100,000 - 1 = -4.59%

Hence, the correct answer is option (C) - 4.59%

Question 11

The euro denominated rate of return on euro-deposit assets = 12 months interest rate on euro deposit assets = 4.50%

Hence, the correct answer is option (A) 4.50%