Question

EAFE Weight Return on Equity Index E1/E0 Manager’s Weight Manager’s Return Europe 0.30 20% 0.9 0.35 18% Australasia 0.10 15 1.0 0.15 20 Far East 0.60 25 1.1 0.50 20 If the current exchange rate is $1.75/£, the 1-year forward exchange rate is $1.85/£, and the interest rate on British government bills is 8% per year, what risk-free dollar-denominated return can be locked in by investing in the British bills?

Answer 1

Let the dollar return be r

The current exchange rate is $1.75 and 1 Year forward exchange rate is $1.85 and the rate British government bill is 8% and here rates are given in indirect Quotes and we have to convert it into direct quotes

spot rate = 1 USD = 1/1.75 and forward rate =1 1 USD= 1/1.85

using interest parity theorem,

Forward rate = spot rate(1+rate of British govt)/(1+reate of domestic co)

1/1.85 = 1/1.75(1.08/1+r)

1.75/1.85 = 1.08/1+r

1+r =1.08(1.85)/1.75

1+r = 1.1417

r= 0.1417 i.e 14.17%