Question

1. Suppose the interest rate on 6-month treasury bills is 7 percent per year in the United Kingdom and 4 percent per year in the United States. Also, today’s spot exchange price of the pound is $2.00 while the 6month forward exchange price of the pound is $1.98. If the price of the 6-month forward pound were to _____, U.S. investors would be indifferent between covered U.K. investment and domestic U.S. investment under exact CD.

a. rise to $1.990

b. rise to $2.012

c. fall to $1.960

d. fall to $1.944

e. None of the above.

2. Suppose in Zurich £/$ = 0.5, while in New York SF/$ = 2.5, but in London £/SF = 0.1. If you begin by holding £1 million, your profit from these exchange rates will be:

a. £1 million

b. £4.2 million

c. £2.5 million

d. £1.5 million

Answer 1

1d. fall to $1.944

The interest rates are currently 4 percent per year for US and 7 percent per year for UK

Suppose he invests 2$ in the US,he gets 2*(1.04) = 2.08$

Now supposing he invests the same in UK,first he gets 1 pound for 2$, then he invests that and gets 1*(1.07) =1.07 pounds at the end

For the investor to be indifferent in investing,the exchange rate 6 months later(or the price of the 6 month forward pound) should be such that 2.08$=1.07 pounds

for such an exchange rate we get 1 pound= 2.08/1.07= $1.9439 or $1.944

so it should fall to 1.944$ for the investor to be indifferent

2a 1 million pounds If you begin by holding 1 million pounds,you can exchange it for 10*1 million pounds to get 10 million SFs(0.1 pounds for SF means 10 SFs for each pound) in London.

Then you can exchange these 10 million SFs in Newyork to get 10/2.5=4 million USDs

After this,exchange the 4 million USDs to get 4*0.5 million= 2 million pounds at Zurich

so you end up with 2 million pounds

Total profit is 2-1 million pounds=1 million pound