Relationship Between Spot and Forward Exchange Rates

Relationship Between Spot and Forward Exchange Rates -...

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Relationship Between Spot and Forward Exchange Rates Suppose you have $10,000 to invest and you've narrowed your investment options to (1) a U.S. government bond with an 8% interest rate or (2) a German government bond with a 6% interest rate. Which bond is the better investment? It all depends on what you expect to happen to the exchange rate between dollars and German marks. You are exposed to exchange rate risk if you purchase the German bond. 2 ways of dealing with risk: 1. contract now to convert DM back into $ at the 1 year forward exchange rate - covered (hedged) 2. wait and convert DM into $ at the future spot exchange rate in 1 year - uncovered (speculation) If you invest in the German bond you must turn your dollars into marks now and back again in one year. Suppose the exchange rate is now $1 = DM 2 or r s = $0.50/DM. $10,000 today = DM 20,000 DM 20,000 + 6% = DM 21,200 after one year Every $ invested yields (1 + i for /r s DM in 1 year. Suppose at the time of investment, you could have contracted to sell DM in the forward market
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Relationship Between Spot and Forward Exchange Rates -...

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