Suppose the 1-year risk-free rate of return in the U.S. is 4% and the 1-year risk-free rate of return in Britain is 6%. The current exchange rate is 1 pound = U.S. $1.67. 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) 1.6385
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 is as follows: Start with $1.67, the current exchange rate. If $1 is invested in the U.S. at 4%, it grows to $1.04 in a year. To match this in Britain, where the rate is 6%, you convert your dollars to pounds at the current rate ($1.67), invest at 6%, and then convert back at the future rate. The calculation for the future rate needed to break even is: $1.67 * (1 + 0.06) / (1 + 0.04) = $1.6385.

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