The 12-month interest rate on dollar-denominated assets (like bank deposits) is 2.00%. The 12-month interest rate on euro-denominated assets is 1.80%. The current spot exchange rate is $1.50 per €. The current forward exchange rate is $1.58 per €. You have an initial dollar fund of $100,000. Suppose that you have decided today to invest your dollar fund in euro-denominated assets while also using the forward exchange market to hedge the exchange risk.
1) Explain what you should do today on the foreign exchange markets.
2) Explain what you should do 12 months from now on the foreign exchange markets.
3) Compute your investment gain in Euros. What is the euro rate of return on your euro deposits?
4) Compute your investment gain in dollars. What is the dollar rate of return on your euro deposits?
5) Is your investment decision consistent with the covered interest parity based on the full formula? Show your calculations to support your answer.
6) Is your investment decision consistent with the covered interest parity based on the approximating formula? Show your calculations to support your answer.