Asked by Femina Asmani on Jul 11, 2024
Verified
Suppose the 1-year risk-free rate of return in the U.S. is 4%, and the 1-year risk-free rate of return in Britain is 7%. The current exchange rate is 1 pound = U.S. $1.65. A 1-year future exchange rate of __________ for the pound would make a U.S. investor indifferent between investing in the U.S. security and investing in the British security.
A) 1.6037
B) 2.0411
C) 1.7500
D) 2.3369
Risk-Free Rate
The theoretical return of an investment with zero risk, often represented by U.S. government bonds.
Future Exchange Rate
An agreed-upon price for exchanging currency at a future date, used in forward contracts and currency futures trading.
Indifferent
A state of having no preference between two or more outcomes or items.
- Understand the implications of exchange rate movements on international investment decisions.
Verified Answer
MM
Maurisio MartinezJul 15, 2024
Final Answer :
A
Explanation :
To make a U.S. investor indifferent between investing in the U.S. and Britain, the future exchange rate must offset the interest rate differential. The calculation involves finding the expected future exchange rate that equalizes the returns in both currencies. Given a 4% return in the U.S. and a 7% return in Britain, the calculation is as follows: 1.65 * (1 + 0.04) / (1 + 0.07) = 1.6037. This means that if the future exchange rate is 1.6037, the U.S. investor would get the same return from investing in either country.
Learning Objectives
- Understand the implications of exchange rate movements on international investment decisions.