Question

# (2) Suppose that you have \$1 to invest. You have two investment options: one is to...

(2) Suppose that you have \$1 to invest. You have two investment options: one is to buy 1-year U.S. bonds that offer a market interest rate of 8% per year, and the other is to buy 1-year Japanese bonds that pay 12% interest per year. Assume that you decide to buy the Japanese bonds with \$1. This time you don’t enter into a forward contract to protect your investment from possible fluctuations in the exchange rate. Today’s exchange rate is ¥100: \$1, and the expected future exchange rate that will prevail one year from today is ¥98: \$1. (You can answer this question step by step as follows.)

1 Calculate the proceeds from investing in the U.S. bonds for one year.
2 Calculate the proceeds from investing in the Japanese bonds for one year.
3 Convert the yen-denominated proceeds into dollars using the future exchange rate one year later. 4 Does the uncovered interest parity condition hold? Could you make more money from your investment in the Japanese bonds rather than your investment in the U.S. bonds?

1.1 Original exchange rate Reciprocal rate Answer
(a) €1 = US\$0.8420 US\$1 = €? 1.1876
(b) £1 = US\$1.4565 US\$1 = £? 0.6866
(c) NZ\$1 = US\$0.4250 US\$1 = NZ\$? 2.3529
1.2 Given
US\$1
US\$1.4560
A\$ = US\$0.5420

¥ .
£
123 25
1
(a) Calculate the cross rate for pounds in yen terms.
¥? £
£
¥ .
£. . ¥

1
1
123 25
1 14560 123 25 179
US\$1.4560
US\$1
.45
(b) Calculate the cross rate for Australian dollars in yen terms.
¥ ?
¥ .
. .¥

A\$
A\$ US\$0.5420
US\$1
A\$
1
1
123 25
1 0 5420 123 25 66 80 .
(c) Calculate the cross rate for pounds in Australian dollar terms.
A\$ £
£ US\$1.4560
US\$0.5420 A\$1
A\$
?
. /. £

1
1
1 14560 0 5420 2 6863

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