Question

2. Suppose a British investor is expected to receive payment of 10,000 dollars ($) in twelve months from a U.S. bank. The annual interest rate in dollar deposit is 5% and the annual interest rate in pound deposit is 10%. If the present exchange rate is 0.50 pound per dollar deposit and interest parity holds, then.

(a) How many pounds does the British investor expect to receive at the maturity date of his      U.S. investment?

(b) How many pounds were initially invested? Fully explain all your answers.

3.

     (a) Suppose a computer sells for US$1,200 in the U.S. and for £855 in London. If the exchange rate is £0.65 per dollar, is there any arbitrage (profit opportunity)? Explain

     (b) If the Canadian dollar price of one Euro was C$1.30 in 2003 and the exchange rate adjusted to 0.85 Euro per C$ in 2004, did the Canadian dollar appreciate or depreciate against the Euro. Explain.

Answer 1

2. If they will receive $10000 in 12 months and the interest rate on dollar deposit is 5%, the they have 10000 / 1.05 = $9523.81 dollars today in their bank, which is equal to 9523.81 * 0.50 = 4761.90 pounds today (today's exchange rate being 0.50)

If these pounds were invested @10%, it would become 4761.90 * 1.1 = 5238.1 pounds at the end of one year.

We can see that since teh interest rate on pounds is higher than on dollars, it results in depreciation of pounds, since the exchange rate one year later would be 5238.1 / 10000 = 0.5239 (as compared to 0.50 today)

3a. Assuming no transportation costs, money can be made as follows:

Use USD1200 to buy one computer in the US

Sell it for GBP 885 in London

Convert this GBP 885 @ 0.65 into USD1361.54, and make a clear profit of USD161.54 per computer

3b. CAD / EURO = 1.30 in 2003

Euro / CAD = 0.85 in 2004, which is equal to CAD / Euro = 1/0.85 = 1.1765

One Euro buys fewer CAD in 2004 than in 2003, hence the CAD has appreciated against the Euro