Question

1. Consider a foreign economy with current exchange rate of 100 units of currency per 1 USD. Investors can buy a US bond paying 3% for a year or can by a foreign bond (with equivalent risk) paying 5% for a year.
   1. a. What exchange rate in a year's time would make investors indifferent between investing in the US or foreign country?
   2. b. Suddenly there is news that the foreign country's inflation rate will be 2% higher. What exchange rate, one year ahead, now makes investors indifferent?

Answer 1

Solution

Example : 2 countries - The United States and India with currencies as $ and ₹

a.It is given that USD / INR = 100 meaning $1 = ₹ 100

Now given that the interest rate is 3% in the US and 5% in India

Suppose an investor has 1$ to invest,then he will get ( 1* 0.03 ) i.e $ 0.03 as interest in the U.S

If invested in India he will get an interest of (₹100 * 0.05 ) i.e.,₹5

In order to be indifferent to this investment the exchange rate should be :  

$0.03-->5

$1--> ?

i.e., 5 / 0.03 ==> ₹166.67

(b)