Question

Given 1-year ZCB securities with 2.5% yield in USD and 0.5% yield in JPY, and a spot exchange rate of USD/JPY at 118.05, what expected spot exchange rate in 1-year would result in a break-even between the two instruments? Which bond would be a better investment given a 1Y forward exchange rate of USD/JPY 119.03?

Answer 1

Part A:

Acc to IRPT,

Fwd rate = Spot rate * [ (1+Hi) / ( 1 + Fi) ]

Hi = Int rate in Japan
Fi = Int rate US

Fwd rate = Spot rate * [ (1+Hi) / ( 1 + Fi) ]

= 118.05 * [ (1 + 0.005) / ( 1 + 0.025) ]

= 118.05 * [ 1.005 / 1.025 ]

= 115.75

Part B:

US Fwd Prmium = [ Fwd rate - Spot Rate ] / SPot Rate

= [ 119.03 - 118.05 ] / 118.05

= 0.98 / 118.05

= 0.0083 i.e 0.83%

Effective Rate in US = 2.5% + 0.83%

= 3.33%

Effectiva rate in Japan = 0.5%

Hence adviced to invest in US.

Pls do rate, if the answer is correct and comment, if any further assistance is required.