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Exchange Rates and the Time Value of Money

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39. The exchange rate between the pound sterling and the dollar is currently $1.50 per pound, the dollar interest rate is 7% per year, and the pound interest rate is 9% per year. You have $100,000 in a one-year account that allows you to choose between either currency, and it pays the corresponding interest rate.

a. If you expect the dollar/pound exchange rate to be $1.40 per pound a year from now and are indifferent to risk, which currency should you choose?

b. What is the "break-even" value of the dollar/pound exchange rate one year from now?

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The expert examines the exchange rates and the time value of money. This posting answers the given problem.

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a. You could invest $1 today in dollar-denominated bonds and have $1.07 one year from now. Or you could convert the dollar today into 2/3 (i.e., 1/1.5) of a pound and ...

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