Question

Current one-year interest rates in Europe is 4 percent, while one-year interest rates in the U.S. is 2 percent. You convert $200,000 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 $1.20.

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 $1.12, what is your percentage return from your investment?

c. If the spot rate of the euro in one year is $1.31, 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?

Answer 1

a.

Borrow $200000 at 2% for one year

Amount in dollars = 200000

Current Spot Rate of the Euro = $1.20

Amount in Euro = 200000/1.20 = 166666.6667

One year Rate of Interest in France = 4%

One year Rate of Interest in US = 2%

After one year

Amount in Euro = 166666.6667(1.04) = 173333.3333

Amount in Dollars  = 200000(1.02) = 204000

Spot Rate of Euro in one year = Amount in Dollars in one year/Amount in Euro in one year = 204000/ 173333.3333

Spot Rate of Euro in one year = $1.1769

b.

Spot Rate of Euro in one year = $1.12

After one year

Amount in Dollars  = 173333.3333*1.12 = $194133.333

% Return =(194133.333 -204000) /204000 = -4.83%

c.

Spot Rate of Euro in one year = $1.31

After one year

Amount in Dollars  = 173333.3333*1.31 = $227066.666

% Return =(227066.666 -204000) /204000 = 11.31%

d.

The Spot Rate of the Euro in one year should be greater than $1.1769 for the strategy to be successful.