Question

Consider a German firm that wishes to invest euro funds for a period of one year. The firm has a choice of investing in a euro bond with one year to maturity, paying an interest rate of 2.25 percent. The current exchange rate is 1.12 euro per U.S. dollar, and the one-year forward exchange rate is 1.25 euro per U.S. dollar. Should the German firm invest in euro bonds or in U.S. dollar bonds?

Answer 1

The German firm should invest in US dollar bonds.

Explanation:

Lets assume the firm has 100 euros to invest.

The amount in euros if the firm invest in euro bonds = 100*(1+2.25/100)

= 102.25 Euros

The amount in euros if the firm invest in US dollar bonds,

At the current exchange rate, ie,

1 dollar = 1.12 Euros

So 100 Euros will be equal to (100/1.12) dollars, ie, 89.2857 dollars

And now converting back the dollars to Euros at the exchange rate after 1 year, ie, 1.25 euro per US dollar.

So 89.2857 dollars will be equal to (89.2857*1.25) Euros.

ie, 111.6071 euros.

So investing in US dollar bonds will fetch more return as compared to euro bonds.