Question

A U.S. investor has borrowed pounds, converted them to dollars, and invested the dollars in the United States to take advantage of interest rate differentials. To cover the currency risk, the investor should:

Answer 1

Answer: C. Buy pounds forward.

Explanation:

The investor borrowed in pounds which means that they would have to pay back in pounds. They would therefore need pounds at the end of the investment period but need to be sure of the rate they are converting back to so as to reduce currency risk.

The way to cater for this risk would be to buy pounds in the forward market at a guaranteed rate so that when they are to pay back the pounds, they buy it at the rate they agreed to in the forward market, regardless of what the rate is in the spot market when they want to pay back the pounds.