Question

S=$/£0.75 ; 1yr bond rate in UK=5% ; 1yr F=$/£0.77; 1Yr bond rate US=2%

A) calculate the return on 1$ invested in the UK, where will global investors choose to invest ?

B) find the spot ratw that makes the return on investments equal across these 2 countries

Answer 1

Ans.

a) $1 when exchanged for £ at spot rate S = £0.75

£0.75's value after 1 year in UK = 0.75*(1+0.05) = £0.7875

£7875 when exchanged for $ at F = 0.7875/0.77 = 1.02272

Thus, $1 becomes $1.02272 after investing in UK. So, rate of return is 2.2272% per annum.

b) From uncovered interest rate parity condition,

F/S = (1+interest in UK)/(1+interest in US)

=> 0.77/S = (1+0.05)/(1+0.02)

=> S = £0.748/$

Thus, present spot price = $/£0.748

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