Question

28. David is trying to decide whether to invest in a domestic certificate of deposit (CD) with a 5 percent interest, or to invest in a British CD bearing an interest of 4.5 percent. He knows that the spot exchange rate E$/ € = 1.32, while the expected exchange rate a year from now is 1.4. If David wants to invest $3,000 for a year, which option should he choose?

1. 1. He should invest in the domestic asset because the rate of return on the British asset is - 5.97 percent.
2. 2. He should invest in the domestic asset because it bears a higher interest rate than the British asset.
   3. He should invest in the British CD because that is likely to yield a return of 11.4 percent.
   4. He should invest in the British CD because that is likely to yield a return of 10.8 percent.

29. Consider an American investor considering both domestic and British investment options. If the rate of return on a British asset is negative, it implies that:

29. 1. the American interest rate on a comparable asset is higher than the British interest rate.
    2. the effect of the British interest rate on the return is stronger than that of the appreciation of the pound.
    3. the depreciation of the pound has a stronger impact on the return than the British interest rate.
    4. the investors are expecting the dollar to depreciate.
30. If E$/€ = 1.28, then $1 will trade for: Select one:

a. €1.28

b. €0.28

         c. €1

d. €0.78

31. Suppose the exchange rate E$/¥ = 0.01172 today. How much yen would you need (approximately) to buy $200 at this exchange rate?

a. ¥2.344

b. ¥17,064.85

c. ¥11.72

d. ¥1,706.48

Answer 1

Question 1

Answer is - He should invest in the British CD because that is likely to yield a return of 10.8 percent.

Total return on British CD = (1 + interest on British CD)*(1+return from changes in exchange rates)

return from changes in exchange rates = (exchange rate one year later/spot exchange rate) - 1 = (1.4/1.32) - 1 = 1.061 - 1 = 0.061 or 6.1%

at current spot rate, one € will get $1.32 but one year later same one € will get more no. of dollars i.e. 1.4.

Total return on British CD = [(1+0.045)*(1+0.061)] - 1 = (1.045*1.061) - 1 = 1.108 - 1 = 0.108 or 10.8%

If he invests in domestic CD then he will earn only 5% interest on it.

Question 2

Answer is - a. the American interest rate on a comparable asset is higher than the British interest rate.

If American interest rate on a comparable asset is higher than investors will buy American assets and sell British assets. this will increase the demand of dollars and it will appreciate against pound.

rest of the option are including return from exchange rate changes which will be part of total return from British asset.

Question 3

Answer is - d. €0.78.

If E$/€ = 1.28, then $1 = 1/1.28 = €0.78.

one € is getting $1.28. so, $1 will get less no. of units of €. $1 = 1/exchange rate.

Question 4

Answer is - b. ¥17,064.85.

amount of yen you need to buy = dollar amount/exchange rate = $200/E$/¥ = 0.01172 = ¥17,064.85