Suppose the 1-year risk-free rate of return in the U.S. is 4.5% and the 1-year risk-free rate of return in Britain is 7.7%. The current exchange rate is 1 pound = U.S. $1.60. A 1-year future exchange rate of __________ for the pound would make a U.S. investor indifferent between investing in the U.S. security and investing in the British security.
A) 1.5525
B) 2.0411
C) 1.7500
D) 2.3369

Question

Quizplus · Accepted Answer

To make a U.S. investor indifferent between investing in the U.S. and Britain, the future exchange rate must offset the interest rate differential. The calculation involves finding the expected future exchange rate that equalizes the returns, using the formula: Future Exchange Rate = Current Exchange Rate * (1 + Foreign Interest Rate) / (1 + Domestic Interest Rate). Plugging in the given values: 1.60 * (1 + 0.077) / (1 + 0.045) = 1.60 * 1.077 / 1.045 ≈ 1.5525.

Suppose the 1-Year Risk-Free Rate of Return in the U