Question

(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?

Answer 1

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