An Irish investor has 100 euros to invest. He has to decide where to invest for the next year. Ireland pays a 4% annual interest rate. The UK pays an annual rate of 2%. The current spot exchange rate of the Euro against the pound is 1.3 euro per pound. The investor forecasts an exchange rate of 1.6 euros per pound for the end of the year. The current forward rate is 1.55 euros per pound.
a) What is the pound-denominated return of 100 Euros invested in the UK for one year?
b) What is the Euro-denominated return of 100 Euros invested in the UK for one year, if the investor does not hedge? Is it more or less money than she can get by investing in Ireland?
c) What is the Euro-denominated annual return of 100 Euros invested in the UK, if the investor hedges? Is it more or less money than she can get by investing in Ireland?
d) What is the end-of-year expected exchange rate that is consistent with UIP?