Question

Susan lives in the US and has $1000 to invest. She has to decide between buying a one year CD (certificate of deposit) from a bank in the US or one in France. The US CD, denominated in dollars, pays an interest rate of 3%, while French CD, denominated in Euro, pays an interest rate of 2%. The dollar-euro spot rate is 1.4 and the dollar–euro forward rate is 1.5. What should Susan do?

Answer 1

Case 1 - Susan invest $1,000 in US

Amount invested = $1,000

Interest rate = 3%

Time period = 1 year

Calculate the amount to be earned in 1-year -

Amount = $1,000(1+0.03)¹ = $1,000 * 1.03 = $1,030

The Susan will have $1,030 after one year if she invests $1,000 in US

Case 2 - Susan invests $1,000 in France -

Amount invested = $1,000

For investing in France, dollars have to be converted into Euros

Dollar-Euro spot rate =$1.4/euro

1 euro = $1.4

$1 = (1/1.4) euro

$1,000 = (1,000/1.4) = 714.28 Euros

So, Susan will invest 714.28 euros in France.

Interest rate = 2% or 0.02

Time period = 1 year

Calculate the amount to be earned in 1-year -

Amount = 714.28(1+0.02)¹ = 714.28 * 1.02 = 728.56 Euros

Converting back to dollars -

Dollar-Euro forward rate = $1.5/Euro

Amount (in dollars) = 728.56 * 1.5 = $1,092.84

The Susan will earn $1,092.84 after one year, if she invests $1,000 in France.

The amount earned is greater in case of investment in France.

So, Susan should invest $1,000 in buying a one-year CD from a bank in France.