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.