The following exchange rates exist on a particular day. Spot exchange rate: U.S. $1.400/euro Forward exchange rate (90 days): U.S. $1.427/euro The following (annualized) interest rates on 90-day government bonds also exist on this day: Euro-denominated bonds: 8% U.S. dollar-denominated bonds: 16%
a. Financial investors in all countries have the expectation that the spot exchange rate in 90 days will be 0.7100 euro/U.S. dollar. Are investors expecting the euro will appreciate or depreciate during the next 90 days?
b. Consider the comparison between investments in U.S. dollar-denominated bonds and euro-denominated bonds, with any foreign investment done as uncovered foreign investment.
In which direction (between the United States and the euro area) will there be an incentive for uncovered investment to flow, based on a comparison of returns?
Calculate the relevant returns and explain your answer.