The rise of globalization is due to the many companies that have become multinational corporations for various reasons—for example, to access better technology, to enter new markets, to obtain more raw materials, to find funding resources, to minimize production costs, or to diversify business risk. This multimarket presence exposes companies to different kinds of risk as well—for example, political risk and exchange rate risk.The relationship between interest rates and exchange rates can be represented through the concept of interest rate parity. Consider the following: An American investor is considering investing $1,000 in default-free 90-day Japanese bonds that promise a 4% annual nominal return.•The spot exchange rate is ¥101.12 per dollar.•The 90-day forward exchange rate is ¥100.25 per dollar. A. The investor’s annualized return on these bonds—if he or she can lock in the dollar return by selling the foreign currency in the forward market—will be ____ . B. Which of the following statements is implied by interest rate parity theory?Interest rates in all countries should be the same. An investment in one’s home country should have the same return as a similar investment in a foreign country. Interest rates in all countries with the same political risk should be the same. A product bought in one country should have the same price in other countries, adjusted for exchange rate.

A. To invest in the Japanese bond the investor has to exchange his currency to Japan’s. for $100 at the spot exchange rate he will get ¥(1000×101.12)=¥101120 Now investing this in the bond, after the 90 days at 4% annual return he will get ¥101120(1+0.04×90365)=¥102117.348 If he then exchanges this according to the forward exchange rate(FER) then after 90 days he will get $(102117.348÷100.25)=$1018.627 Annual return will then be $1018.627-$1000$1000×36590×100=7.6%B. Option-A is incorrect because the interest rates in different countries are very unlikely to be the same, also it depends on the asset quality and other factors. Option-B is correct because if the returns on the two similar assets are not the same in the two countries, then money will flow out of country with lower return and into the country with a higher return. Gradually these two returns will be same. Option-C is incorrect because political risk is not the only factor that determines the interest rates. Option-D is incorrect because this is the statement of purchasing power parity(P-P-P) and not of interest rate parity.

Answered: An American investor is considering…

ENGR.ECONOMIC ANALYSIS

14th Edition

ISBN:9780190931919

Author:NEWNAN

Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

Problem 1QTC

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The rise of globalization is due to the many companies that have become multinational corporations for various reasons—for example, to access better technology, to enter new markets, to obtain more raw materials, to find funding resources, to minimize production costs, or to diversify business risk. This multimarket presence exposes companies to different kinds of risk as well—for example, political risk and exchange rate risk.

The relationship between interest rates and exchange rates can be represented through the concept of interest rate parity. Consider the following:

An American investor is considering investing $1,000 in default-free 90-day Japanese bonds that promise a 4% annual nominal return.

•	The spot exchange rate is ¥101.12 per dollar.
•	The 90-day forward exchange rate is ¥100.25 per dollar.

A. The investor’s annualized return on these bonds—if he or she can lock in the dollar return by selling the foreign currency in the forward market—will be ____ .

B. Which of the following statements is implied by interest rate parity theory?

Interest rates in all countries should be the same.

An investment in one’s home country should have the same return as a similar investment in a foreign country.

Interest rates in all countries with the same political risk should be the same.

A product bought in one country should have the same price in other countries, adjusted for exchange rate.

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