Question

The risk-free rate in Area A is 4 percent, the risk-free rate in Area B is 7.2 percent, and the exchange rate between the currencies of A and B is A0.515/B. One-year forward contracts are available at A0.5/B. You have one million units of currency A. Compare investing that money in Area A versus investing it in Area B. How many units of currency A is that difference?

Answer 1

Investing in A

amount received after 1 year = amount invested * (1 + interest rate in A)

amount received after 1 year = 1,000,000 * (1 + 4%) = 1,040,000.00

Investing in B

• 1,000,000 of Currency A is converted into Currency B at the spot rate. Amount of Currency B received = 1,000,000 / 0.515 = 1,941,747.57
• The Currency B received is invested at the B interest rate for 1 year.  A1,941,747.57 =  1,941,747.57 * (1 + 7.2%) = 2,081,553.40
• The amount of Currency B received after 1 year is converted back into Currency A. Amount of Currency A received =  2,081,553.40 * 0.5 = 1,040,776.70

Difference =  1,040,776.70 - 1,040,000.00

Difference = 776.70 units of currency A