Question

Answer based on the following: Interest rate on U.S. assets = 5%, interest rate on European assets = 12%, the spot rate of exchange = 0.90 Euros/$, the one year forward rate of exchange = 0.95 EUROS/$. The expected rate of return on foreign assets (Dollar assets) for the European citizen is,

1) 6.9%

2) 6.44

3)10.56%

4) 12%

5) 5%

Answer 1

Suppose, the European citizen has 100 Euros to invest in foreign assets (dollar assets).

Converting 100 euros in to dollars at spot exchange rate.

Spot exchange rate = 0.90 Euros/$ or $1.11/euro

So,

100 Euros = 1.11 * 100 = $111

$111 are invested in United States.

Interest rate on US assets = 5% or 0.05

Interest earned in one year = 111 * 0.05 = 5.55

Total amount = 111 + 5.55 = $116.55

Coverting back to euro after one year.

One year forward exchange rate = 0.95 euros/$

so,

$116.55 = 0.95 * 116.55 = 110.72 euros

Expected rate of return = [(110.72 - 100)/100] * 100 = 10.72%

This is nearest to 10.56%.

Hence, the correct answer is the option (3).