Question

An American investor has 2,000 dollars. They come to you to advise them in two different investment options:
choice a. They place the money in a bank in Atlanta.
choice b. They can place the money in a bank in London.

There's a 1- yr interest rate on bank deposits and it is 4% in Atlanta and 2% in the London.
The 1-yr forward dollar/euro exchange rate (F$/e) is 0.9 dollar per euro and the spot rate (E$/e) is 0.85 dollar per euro. Using the exact equations for UIP and CIP, What is the return on choice a (dollar deposit) for the investor and what is the return on choice b (euro deposit) in which investor uses a Forward Contract?

Answer 1

Investor has 2000 $

Choice a

Place money in a bank atlanta.

Deposit after one year = 2000 * (1.04) = 2080

Choice b

To deposit in london exchange $ to € = 2000/0.85 = € 2352.9412

After depositing € 2352.9412 enter in to 1 yr fwd 0.9 € / $

Deposit after maturity = € 2352.9412 * 1.02 = € 2400

Convert € 2400 in to $ on maturity = € 2400 * 0.9 = $ 2160

From the above options choice b is the better option

Return on choice b = 2160-2000 = 160

% of Return = 160 / 2000 = 8%