Question

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 and that you enter into a 1-year forward contract to protect your investment from possible fluctuations in the exchange rate. The forward contract involves the sale of the yen investment proceeds (principal + interest earnings) for dollars to be delivered one year later. Today’s exchange rate is ¥100: $1, and today’s forward exchange rate to be delivered one year from today is ¥104: $1. (You can solve this question step by step as follows.)

1 Calculate the proceeds (principal plus interest) 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 forward exchange rate one year later.

4 Does the covered 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