Question

Suppose the U.S. dollar interest rate is 5% and the euro interest rate is 6%. Assume no transaction costs, fees, or commissions. In all markets, the spot rate for euros is $1.25. You believe in one year's time the spot rate for euros will be $1.30. An investor would like to invest $100,000 for one year and is willing to take on risk for a higher return. a. How would you advise him? (Provide Numerical Support)(8 points)

Answer 1

If the investor invests in dollars,

Total amount after 1 year in dollars = 100,000 x 1.05 = 105,000

Profit in dollar = 105,000 - 100,000 = 5,000

If the investor invests in euro,

Value of euro invested = 100,000 / 1.25 = 80,000 euro

Total amount after 1 year in euro = 80,000 x 1.06 = 84,800

Total amount after 1 year in dollars = 84,800 x 1.30 = 110,240

Profit in dollar = 110,240 - 100,000 = 10,240

Since profit is higher, the investor should convert $100,000 to euro, invest in for one year and convert it back to dollar after one year to maximize his gains.