Question

. Assume that the dollar-Euro exchange rate (E$/€) = 1.1, the U.S. interest rate is 4% and the Euro interest rate is 1%, and that covered interest parity holds. a. How many Euros will an American investor with $1,000 have a year from now? b. What is the forward exchange rate (F$/€) ?

Answer 1

Answer:

1) €918

2) E$/€)= 1.13

Explanation:

1) the dollar-Euro exchange rate (E$/€) if 1.1 means that from one Euro you can buy 1.1 dollars. So if an American investor invests $1,000 today in Euros he will get 1000/1.1= 909.09 Euros. Then if he invests 909.09 euros at an interest rate of 1% he will have (909.09*1.01)=918 euros.

The formula for forward exchange rate is

FWD= Spot price *(1+Interest rate of variable currency *Days/Annual Base)/(1+interest rate of base currency *days/annual base)

In this case the spot price is 1.1, the euro is the base currency and the dollar is the variable currency. The annual base is 365 and the days are also 365 since the we to find 1 year forward rate so days/annual base is 1.

FWD= 1.1*(1.04*1)/(1.01*1)= 1.13

This means that in a one year forward one Euro will cost $1.13