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Question
The spot exchange rate in New York is 1.600 dollars per British pound. The 360-day forward exchange rate is 1.680 dollars per pound. The one-year interest rate in Great Britain is 2% while the one-year interest rate in the United States is 4%.a. If the interest rate in Great Britain remains at 2%, what should the interest rate be in the United States according to the interest rate parity theory?
b. An American investor with $40,000 decides to take advantage of the differences in rates. Ignoring transaction costs, how can the American investor exploit the disequilibrium? Compare the amount of money the investor will have at the end of the year if he or she invests in one-year U.S. securities versus one-year British securities.
Answer
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