Question

The following rates exist: Current spot exchange rate: $1.80/£ Annualized interest rate on 90-day dollar-denominated bonds: 8% (2% for 90 days) Annualized interest rate on 90-day pound-denominated bonds: 12% (3% for 90 days) Financial investors expect the spot exchange rate to be $1.77/£ in 90 days.

a. If he bases his decisions solely on the difference in the expected rate of return, should a U.S.-based investor make an uncovered investment in pound-denominated bonds rather than investing in dollar-denominated bonds?

Answer 1

Suppose the US based Investor had $100 with him.

A) If he makes the investment in US dollar denominated bonds @8% p.a for 90 days, then at the end of the 90 days he will have:

$100 + ($100 * 2%) = $102

B) If he wants to invest in Pound denominated bonds @9% for 90 days, then first he will have to buy Pound:

$100 = ($100/1.8) = £55.56 {Convention at spot rate where £1 = $1.8}

Investing the same for 90 days, at the end of 90 days he will have:

£55.56 + (£55.56 * 3%) = £57.23

Converting the Pounds to Dollars at Spot rate (Spot rate after 90 days of investment):

£57.23 * 1.77 = $101.29

From the above calculation, we can conclude that Option A is better as it's return is higher. Thus the US based Investor should invest in the Dollar denominated bonds.