Gladys Smith has saved up $2,000 for investing purposes. She sees that the CD rate in Japan is 6% for the coming year and only 4% in the United States
She also sees that the current indirect exchange rate is 110 yen per dollar. Looking at the forward rates, Gladys sees that the one-year forward indirect rate is 115 yen per dollar. Can she exploit this situation to her gain? Explain.
What will be an ideal response?
Answer: Gladys has two choices: invest in the United States and get a 4% increase on her $2,000, or invest in Japan at 6% with the need to convert current cash at 110 yen per dollar and the ability to convert future cash at 115 yen per dollar with a forward exchange rate contract.
Year-End Results of U.S. Investing:
$2,000 × 1.04 = $2,080.
Year-End Results of Japanese Investing:
Convert on Day One: $2,000 × 110 = ¥220,000;
Investment growth in Japan = ¥220,000 × 1.06 = ¥233,200;
Convert back at end of year = ¥233,200 / 115 = $2,027.83.
Apparently, the rising exchange rate offsets any potential gain Gladys might get from investing her money in the country with the higher investment rate.
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