Question

If the current exchange rate is $2.05/£, the one-year forward exchange rate is $2.15/£, and the interest rate on British government bills is 4% per year, what risk-free dollar-denominated return can be locked in by investing in the British bills? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Risk-free dollar-denominated return

%

Answer 1

To calculate this, we start with $100 and convert it to Pounds. Hence, it will give us 100/2.05 = 48.78048 Pounds. Then we put this money on interest by buying the British government bills. So, after one year, the total proceeds will be 48.78048 x (1+0.04) = 50.731 Pounds. Now, we convert it back to dollars by using the forward exchange rate. So, we will have = 50.731 x 2.15 = 109.071. Hence, the risk-free return will be = (109.071 - 100)/100 = 9.071% = 9.07%