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 U.S citizen should hold which asset?

1) The Euro asset

2) The Dollar asset

Answer #1

In a foreign exchange market, interest rate parity must always hold. If there is not parity then it is possible to make money by holding a particular portfolio.

According to interest rate parity, differential of interest rate in favor of foreign equals devaluation rate of foreign firm.

So in our case, fair forward price must be: 0.9 * (1+.12)/(1+0.05)

= 0.96

Hence fair value of forward is 0.96. And prevailing market price of forward is 0.95. Hence investor can make profit by building a portfolio where he loans money in dollar and invests in euro assets for 1 year and simultaneously buy a forward at 0.95

Hence he would hold a euro asset.

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%

TIme remaining 1 hour
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