Question

Sup Suppose that the treasurer of IBM has an extra cash reserve of $3,000,000 to invest for six months. The six-month interest rate is 8% per annum in the U.S. and 6% per annum in Germany. Currently, the spot exchange rate is DM1.60 per dollar and the six-month forward exchange rate is DM1.56 per dollar. The treasurer of IBM does not wish to bear any exchange risk. Where should he/she invest to maximize the return?

Answer 1

Solution:-

Cash reserve= $3,000,000

a) If the cash is invested in USA

Amount to be received after 6 month= Deposit amount*(1+perodic interest rate)

= $3,000,000*(1+8%/2)= $3,000,000*(1+4%) =$3,120,000

b) If the amount is invested in Germany and taken forward contract

Step 1:- Convert $ into "DM" at spot rate

      $3,000,000=3,000,000*1.60 DM= DM4,800,000

Step 2:- Take forward contract at 1$=DM1.56

Step 3:- Deposit the converted cash in Germany for six month

Amount after 6 month = DM4,800,000*(1+6%/2)=DM4,944,000

Step 4:- Convert DM into $ by using forward rate

DM4,944,000= $4,944,000/1.56= $3,169,230.77

The amount after 6 month = $3,169,230.77

Since the amount to be received is higher in second option hence he/she should invest in Germany and take forward contract.

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