If the current exchange rate is US$1 equals € .70, how much did you win in US dollars?
Suppose that the interest rate in Irish banks is 2% for a one year CD. In the USA, the rate is 4% for a one year CD. If you left your winnings in Ireland, how many euros would you have in a year? If you had taken your winnings back to the USA, how many dollars would you have?
Suppose when you cashed in your CD in Ireland a year from now, the exchange rate had changed from US$1 to € .70 to US$1 to € .65. How much would your Irish bank account be worth in US dollars at that point? Would you have been better off leaving your winnings in Ireland or bringing them home to the USA?
Explain how banks and individuals can use “covered interest arbitrage” to protect themselves when they make international financial investments.
Using the theory of purchasing power parity, explain how inflation impacts exchange rates. Based on the theory of purchasing power parity, what can we infer about the difference in inflation between Ireland and the USA during the year your lottery winnings were invested?
a. since 1 dollar = .70 euros
.70 euros = 1 dollar
Dividing both sides by .70,
then 1 euro = 1/.70 dollar
1,000,000 euros = 1,000.000 (1/.70) dollars
= $1,428,571.43
b. Since the interest rate is 2% (in Irish bank), 1,000,000 euros after one year =
1,000,000 + 2%(1,000,000) or 1,000,000 (1 + .02) = 1,000,000 (1.02)
= 1,020,000 euros
c. The 1,020,000 euros converted to US dollars at $1 = .70 euros
1,020,000 euros = 1,020,000/.70 dollars
= $1,457,142.86
d. At $1 = .65 euro
1,020,000 euros - 1,020,000/.65 dollars
= $1,569,230.77
e. 1,000,000 euros which is equivalent to $1,428,571.43, invested in US bank at 4% is
= $1,428,571.43 + 4%($1,428,571.43)
= $1,428,571.43 (1 + 4%)
= $1,428,571.43 (1 +.04)
= $1,428, 571.43 (1.04)
= $1,485,714.29
This amount is less than the $1,569,230.77 value of the money after one year if left in Irish bank.
Explain how banks and individuals can use “covered interest arbitrage” to protect themselves when they make international financial investments.
Explain how banks and individuals can use “covered interest arbitrage” to protect themselves when they make international financial investments.
To calculate the amount won in US dollars, we need to know the amount won in euros and the exchange rate. Since €1 equals US$0.70, we can multiply the amount won in euros by the exchange rate to get the amount won in US dollars.
To determine the amount of euros you would have in a year if you left your winnings in Ireland, we need to consider the interest rates in Irish and US banks. For a one year CD, the interest rate in Irish banks is 2% and in US banks it is 4%. Assuming your winnings are kept in a CD for a year, you can calculate the value of your winnings in euros after one year using the following formula:
Final Value = Initial Value * (1 + Interest Rate)
So, the final value of your winnings in Ireland after one year can be calculated as follows:
Final Value in euros (Ireland) = Initial Value in euros * (1 + 2%)
To determine the amount of dollars you would have if you had taken your winnings back to the USA, we need to consider the current exchange rate and the interest rate in US banks. Using the same formula as above, the final value of your winnings in the USA after one year can be calculated as follows:
Final Value in dollars (USA) = Initial Value in dollars * (1 + 4%)
To calculate the worth of your Irish bank account in US dollars a year from now, we need to consider the new exchange rate. If the exchange rate changes to US$1 equals €0.65, we can multiply the final value of your Irish bank account in euros by the new exchange rate to get the worth in US dollars.
Worth in US dollars = Final Value in euros (Ireland) * New Exchange Rate (US$/€0.65)
To determine whether it would have been better to leave your winnings in Ireland or bring them back to the USA, compare the worth of your Irish bank account in US dollars at that point to the amount you would have if you had brought your winnings back to the USA.
Covered interest arbitrage is a strategy used by banks and individuals to protect themselves when making international financial investments. It involves taking advantage of interest rate differentials between two countries while also covering the foreign exchange risk through hedging.
In covered interest arbitrage, banks and individuals borrow funds in a country with a lower interest rate and then convert the borrowed funds into the currency of a country with a higher interest rate. The borrowed funds are invested in assets in the higher-interest-rate country. At the same time, the investor enters into a forward contract to sell the higher-interest-rate currency at a future date at a fixed exchange rate. This way, any potential losses due to the exchange rate fluctuations are covered.
The theory of purchasing power parity (PPP) states that the exchange rate between two currencies should equal the ratio of their price levels. In other words, the exchange rate should adjust to maintain the same purchasing power in each country.
Inflation impacts exchange rates based on the theory of purchasing power parity. If a country has higher inflation than another, its currency should depreciate relative to the other country's currency. This is because the higher inflation reduces the purchasing power of the currency, making it less valuable compared to the currency of the country with lower inflation.
Based on the theory of purchasing power parity, if inflation in Ireland is higher than in the USA during the year your lottery winnings were invested, we can infer that the exchange rate should have adjusted to reflect the difference in inflation. This means that the value of the euro would have decreased relative to the US dollar, indicating that the inflation in Ireland was higher than in the USA.