Question

Suppose that the treasurer of IBM has an extra cash reserve of $100,000,000 to invest for six months. The interest rate is 10 percent per annum in the United States and 9 percent per annum in Germany. Currently, the spot exchange rate is €1.13 per dollar and the six-month forward exchange rate is €1.11 per dollar. The treasurer of IBM does not wish to bear any exchange risk. Where should he or she invest to maximize the return?

Answer 1

Sol:

Cash reserves = $100,000,000

Annual interest rate in United States = 10%, Semiannual = 10 / 2 = 5%

Annual interest rate in Germany = 9%, Semiannual = 9 / 2 = 4.5%

Spot exchange rate = €1.13 per dollar

Six-month forward exchange rate = €1.11 per dollar.

We have to first compute the maturity value of $100,000,000 cash reserves invested in U.S:

Maturity value for investment in U.S = 100,000,000 * (1+ 5%) = $105,000,000

Now convert the cash reserves of $100,000,000 into euros and then invest the reserve money at German interest rate with the forward contract sold at euro maturity. So the maturity value in dollar will be as follows:

Maturity value = (100,000,000 * 1.13) * (1 + 0.045) * (1 / 1.11)

Maturity value = 113,000,000 * 1.045 * 0.9009 = $106,382,882.88

Therefore to maximize the return investment in Germany is feasible, as the maturity value of investing in Germany taking into consideration the hedging risk will be higher than investing in U.S.