Question

If you are a Japanese producer who sells products in the US, you want a foreign exchange future without going through the futures market. So, you borrow money in dollars with an interest rate of 5% and immediately convert it to yen at a rate of 1 dollar to 100 yen. Then you put the money in a Japanese interest-bearing account with an interest rate of 10%. What is the forward exchange rate in this case?

Answer 1

Answer:

104.76 yen per dollar

Explanation:

the forward rate = spot rate x [(1 + foreign interest rate) / (1 + domestic interest rate)] = 100 yen x [(1 + 10%) / (1 + 5%)] = 100 yen x (1.1 / 1.05) = 104.76 yen per dollar

Since the interest rate in Japan is higher than the interest rate in the US, investors will start to purchase more yens in order to gain higher interest rates, which will eventually appreciate the yen against the dollar until both interest rates match.