Question

Interest rate in US (Rh): 3.5%

Interest rate in Euro zone (Rh): 7.5%
Line of credit in US: USD 10,000,000
Line of credit in in Euro zone: EUR 8,000,000
The spot rate of EUR, now (SR0): $1.25

Suppose your forecast tells you that the spot rate of EUR one year later (SR1) will be $1.20. What is your uncovered rate of return from US (Ruh) and Euro zone (Ruf)?

Answer 1

(US): 3.20%

EURo zone :7.81%

Step-by-step explanation:

As per Uncovered Interest rate parity theory,

Expected Spot Rate / Spot Rate = (1 + time adjusted interest rate of $) / (1 + time adjusted interest rate of Euro)

To find Uncovered rate of return from US (Ruh), we put expected spot rate, spot rate and time adjusted interest rate of Euro in above equation :

$ 1.20 / 1.25 = (1 + 1* interest rate of $) / (1 + 1*0.075)

Hence, Interest Rate of $ = 3.2%

Hence, Uncovered rate of return from US (Ruh) is 3.20%.

Similarly, to find Uncovered rate of return from Euro zone (Ruf), we put expected spot rate, spot rate and time adjusted interest rate of US in above equation :

$ 1.20 / 1.25 = (1 + 1*0.035) / (1 + 1* interest rate of euro)

Hence, interest rate of Euro = 7.81%.

Hence, Uncovered rate of return from Euro zone (Ruf) is 7.81%.