Suppose the 1-year risk-free rate of return in the USA is 5% and the 1-year risk-free rate of return in Britain is 8%.The current exchange rate is $1 = ₤0.50.A
1-year future exchange rate of __________ would make a U.S.investor indifferent between investing in the U.S.security and investing in the British security.

Question

Quizplus · Accepted Answer

To determine the future exchange rate that would make the U.S. investor indifferent between investing in the U.S. security and investing in the British security, we need to calculate the expected return on investing in each security.
Expected return on U.S. security = 5%
Expected return on British security = 8% + (future exchange rate - spot exchange rate)/spot exchange rate
Since the U.S. investor is indifferent, the expected returns on both securities must be equal. Solving for the future exchange rate:
5% = 8% + (future exchange rate - 0.50)/0.50
0.30 = future exchange rate - 0.50
future exchange rate = 0.50 + 0.30 = 0.80
Therefore, the 1-year future exchange rate that would make the U.S. investor indifferent is ₤0.80. However, this is not one of the answer choices. The closest answer choice is B, ₤0.5142, which is likely the result of rounding.

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