Question

Dollar Return on Foreign Investments -

(A) Over the past year, the dollar has appreciated by about 8 percent against the peso. A year ago you borrowed in the U.S. at an interest rate of 4 percent and you invested the money in a Mexican mutual fund that paid a 12 percent peso return. What net return did you earn on all of these transactions over the year? (PLEASE INCLUDE FORMULAS USED TO SOLVE PROBLEM).

(B) Explain the following statement: If inflation differences are the only reason that interest rates are higher in one country than another, it is highly unlikely that arbitrage profits will exist in these countries' financial markets. (PLEASE INCLUDE FORMULAS USED TO SOLVE PROBLEM).

(C) Over the past year, the dollar has depreciated by about 10 percent against the euro. A year ago you took out a home equity loan in the U.S. at an interest rate of 8 percent and you invested the money in a German mutual fund that paid a 5 percent euro return. What net return did you earn on all of these transactions over the year? (PLEASE INCLUDE FORMULAS USED TO SOLVE PROBLEM).

(D) You can borrow or invest in the U.S. at an annual rate of 6 percent. Suppose you logon to your favorite financial website and see that you could borrow or invest in Japan at a 5 percent annual rate. The current exchange rate between the dollar and the yen is $0.01/yen. You can use the futures market to lock it in at an exchange rate for one year from now at $0.0095/yen. Is there a profit opportunity here? Prove it by borrowing (either $1 million or $100 yen) in one country and investing in the other? (PLEASE INCLUDE FORMULAS USED TO SOLVE PROBLEM).

Answer 1

Answer A)

appreciated by about 8 percent against the peso. A year ago you borrowed in the U.S. at an interest rate of 4 percent and you invested the money in a Mexican mutual fund that paid a 12 percent peso return.

The profit in investment ( the difference in interest rate in two currency (peso - us$)) = 12-4 = 8%

Appreciation in currency = 8%

Net gain in transaction = difference in interest rate - Appreciation in currency

= 8% - 8% = 0 %

Answer b) If inflation differences are the only reason that interest rates are higher in one country than another, it is highly unlikely that arbitrage profits will exist in these countries' financial markets.

In the such case theory of purchase power parity will play its role ito create equillibrium in exchange rate market as the exchange rate will change in equivalent diffrence of interest rate.

Answer c)

depreciated by about 10 % in dollar against euro ,

Investment return in MF in euro = 5%

Net gain from investment = 10 + 5 = 15%

Cost of loan = 8%

Net gain in the transaction = 15 - 8 = 7%

Answer d)

The current exchange rate between the dollar and the yen is $0.01/yen

The futures exchange rate for one year from now at $0.0095/yen

Change in Exchange rate = ( 0.01- 0.0095)/0.01 = 0.05 = 5%  

5% depreciationin yen /US$

So, Borrow in Japan @ 5% invest in US @ 6% for year

Net return = difference in interest rate + change in exchange rate = (6-5)+ 5 = 6% .