Question

3. Assume that the interest rate on a one-year treasury bill is 3% and that of a one year Eurobond is 1.5%. Also assume that CIP holds in the Forex. If the spot exchange rate is $1.0832 and the forward exchange rate is 1.1075 where will investors invest their money? Also compute the covered interest differential.

Answer 1

From Covered interest rate parity,

Forward interest rate (F)/ Spot rate (S)= (1 + US interest rate)/(1+ Eurodollar interest rate) - 1

=> F/ 1.0832 = (1+0.03)/(1+0.015)

=> F = $1.0992

Thus, dollar is undervalued in forward market for exchange rate us $1.1075, so, investors will eurobond will pay higher return if with the investment in bond a short position in forward market for foreign currency should to be taken.

Covered interest rate differential = (1+0.03)/(1+0.015) - 1 = 1.477%

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