Increase the return without any exchange risk

Question

Suppose that treasurer of IBM has an extra cash reserve of $1,000,000 to invest for the six months. Six-month interest rate is 8% per annum in U.S. and 6% per annum in the Germany. Presently, spot exchange rate is DM1.60 per dollar and six-month forward exchange rate is DM1.56 per dollar. Treasurer of the IBM does not want to bear any exchange risk. Where should he/she invest in order to increase the return?

Answer 1

Conditions of market can be summarized as:

   I$ = 4%; iDM = 3%; S = DM1.60/$; F = DM1.56/$.

If $1,000,000 is invested in U.S., maturity value in the six months will be

        $1,040,000 = $1,000,000 (1 + .04).

On the other hand, $1,000,000 is converted into the DM and is invested at German interest rate, having DM maturity value sold forward. In this case dollar maturity value will be

        $1,056,410 = ($1,000,000 x 1.60)(1 + .03)(1/1.56)

Evidently, it is better to invest $1,000,000 in the Germany with exchange risk hedging.