Question

Assume the dollar interest rate is 10 percent while the euro interest rate is 6 percent. Under what circumstances would an investor be indifferent between holding deposits denominated in dollars and holding deposits denominated in euros? Explain.

Answer 1

Suppose there are x dollars of investment being made. After an year, the x dollars will convert into 1.1x dollars that are after getting paid 10 percent interest rate assuming that it is an annual rate.

Now similarly for euros. y euros will change into 1.06 euros at the end of year 1 after recieving interest. So in order to hold deposits dominated in dollars or euros indifferent, the year end post interest dollar value must be equal to the post interest euros being converted into dollars.

So, 1.1x=1.06y. (x/y) (1)

x/y being the exchange rate between dollars and euro. x/y shows the number of dollars one would get by exchanging 1 euro.

Solving (1) will give us (x/y) as 1.0377.

So, when the exchange rate between dollars and euro is 1.0377 or when 1 euro will be exchanged for 1.0377 dollars, the depositor would be indifferent between a dollar or a euro deposit.