George Smith has saved up $10,000 for investing purposes. He sees that the CD rate in Japan is 5% for the coming year and only 4% in the United States
He also sees that the current indirect exchange rate is 120 yen per dollar. Looking at the forward rates, George sees that the one-year forward indirect rate is 125 yen per dollar. Can he exploit this situation to his gain? Explain.
What will be an ideal response?
Answer: George has two choices: invest in the United States and get a 4% increase on his $10,000, or invest in Japan at 5% with the need to convert current cash at 120 yen per dollar and the ability to convert future cash at 125 yen per dollar with a forward exchange rate contract.
Year-End Results of U.S. Investing:
$10,000 × 1.04 = $10,400.
Year-End Results of Japanese Investing:
Convert on Day One: $10,000 × 120 = ¥1,200,000;
Investment growth in Japan = ¥1,200,000 × 1.05 = ¥1,260,000;
Convert back at end of year = = $10,080.
Apparently, the rising exchange rate offsets any potential gain that George might get from investing his money in the country with the higher investment rate.
One might also notice that the implied forward rate, given these rates of inflation, is ¥120 × = ¥121.154 / $1, which is much less depreciation in the yen than the existing forward rate. So clearly, the forward rate of ¥125/$ is very unattractive to holders of yen-based investments relative to dollar-based investments.
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