Question

# Current one-year interest rates in Europe is 2 percent, while one-year interest rates in the U.S....

Current one-year interest rates in Europe is 2 percent, while one-year interest rates in the U.S. is 1.5 percent. You convert \$100,000 to euros and invests them in France. One year later, you convert the euros back to dollars. The current spot rate of the euro is \$1.28.

a. According to the IFE, what should the spot rate of the euro in one year be?

b. If the spot rate of the euro in one year is \$1.20, what is your percentage return from your investment?

c. If the spot rate of the euro in one year is \$1.35, what is your percentage return from your investment?

d. What must the spot rate of the euro be in one year for your strategy to be successful?

a). S1 = S0 x [(1 + iU.S.) / (1 + iEuro)]

= 1.28 x [1.015 / 1.02] = 1.28 x 0.9951 = \$1.274/euro

b).

1. Convert dollars to euros: \$100,000/\$1.28 = €78,125.

2. Invest euros for one year and receive €78,125 × 1.02 = €79,687.50.

3. Convert euros back to dollars and receive €79,687.50 × \$1.20 = \$95,625

The percentage return = \$95,625/\$100,000 – 1 = 0.95625 – 1 = -0.0438, or -4.38%

c).

1. Convert dollars to euros: \$100,000/\$1.28 = €78,125.

2. Invest euros for one year and receive €78,125 × 1.02 = €79,687.50.

3. Convert euros back to dollars and receive €79,687.50 × \$1.35 = \$107,578.125

The percentage return = \$107,578.125/\$100,000 – 1 = 1.0758 – 1 = 0.0758, or 7.58%

d). The strategy would be successful if the spot rate of the euro in one year is greater than \$1.274.

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