Question

1. The following conditions exist in the foreign exchange market:

Current spot rate: 0.876 Euros / U.S. $

Annualized interest rate on 90-day dollar-denominated bonds: 4%

Annualized interest rate on 90-day Euro-denominated bonds: 3%

All financial investors expect the spot exchange rate to be 0.85 Euros / U.S. $ in 90 days.

1. If a U.S. investor bases decisions solely on the expected rate of return, should that investor buy Euro-denominated bonds or dollar-denominated bonds? Briefly explain.
2. If a European investor bases decisions solely on the expected rate of return, should that investor buy Euro-denominated bonds or dollar-denominated bonds? Briefly explain.
3. If these two investors’ decisions are typical of other investors in the U.S. and Europe, what pressure is placed on the current spot exchange rate? Which currency will depreciate and which one will appreciate?

Answer 1

a)current spot rate = 0.876 euros/$ ( taking US as foreign currency and EUROS as domestic currency)

let i be the rate on dollar denominated bonds = 4%

let i* be the rate on euro denominated bonds =3%

expected spot rate after 3 months = 0.85 euros/$ . This shows there is expectation of appreciation of euros or depreciation of US$. THIS is when the US$ is on forward discount.

FD/FP= (EXPECTED SPOT RATE AFTER 3 MONTHS- PRESENT SPOT RATE )/PRESENT SPOT RATE

The interest parity condition says

i=i* + (FD/FP)

FD in this case =( 0.85-0.876)/0.876= -0.02968

now the COVERED INTEREST ARBITRAGE MARGIN (CIAM)= (i-i*)-(FD/FP)

OR CIAM = (i-i*)/1+i*)-(FD/FP)

HERE CIAM = (0.03-0.04)/(1+0.04)+0.02968

= 0.02008.

The CIAM is positive which means the interest differential in favour of US is overpowered by the expected appreciation of EUROS . THUS there will be inflows into euro denominated bonds

therefore , i brief for a US investor , though the rate on bonds is higher in US but expected depreciation of US $ or expected appreciation of EUROS leads him to investing in EURO BONDS .Each eurobond will fetch him more after 3 months.

b) for a european based investor he should also invest only in euro denominated bonds as though interest rate in US bonds is higher but is overpowered by an expected appreciation of euro which will fetch him less euros after 3 months.

ALL IN ALL THE DECISION TO INVEST IN DOMESTIC COUNTRY OR FOREIGN COUNTRY DEPENDS ON CIAM . IF INTEREST DIFFERENTIAL IN FAVOUR OF FOREIGN COUNTRY IS OVERPOWERED BY AN EXPECTED APPRECIATION OF DOMESTIC CURRENCY , IT WILL LEAD TO INFLOW OF FUNDS OR INVESTMENT IN DOMESTIC BONS. THE SAME THINGS IS SHOWN FRO US'S POINT OF VIEW. AN EXPECTED APPRECIATION OF EURO MEANS AN EXPECTED DEP. OF US$.

C) Now since everybody will be investing in euro denominated bonds, the demand for euros will increase or demand for us $ will fall.The spot rate which is euros/us$ will fall .This means an appreciation Of euro (euros/us$) . on the other hand depreciation of US $.