Assume that the treasurer of IBM contains an extra cash reserve of $1,000,000 to invest for six months. The six-month interest rate is 8% per annum in the U.S. and 6% per annum in Germany. Now, the spot exchange rate is DM1.60 per dollar and the six-month forward exchange rate is DM1.56 per dollar. The treasurer of IBM does not hope to bear any exchange risk. Where should he/she invest to maximize the return?
The market conditions are summarized as:
I$ = 4%; iDM = 3%; S = DM1.60/$; F = DM1.56/$.
If $1,000,000 is invested in the U.S., the maturity value in six months will be following
$1,040,000 = $1,000,000 (1 + .04).
On the other hand, $1,000,000 can be converted into DM and invested at German interest rate, along with the DM maturity value sold forward. In this case the dollar maturity value will be following
$1,056,410 = ($1,000,000 x 1.60)(1 + .03)(1/1.56)
Obviously, it is better to invest $1,000,000 in Germany by means of exchange risk hedging.