The current rates are: (1) Spot exchange rate: $2.00/£; (2) 90-day USD denominated bonds: 2% (8% annual); (3) 90-day UK pound denominated bonds: 4% (16% annual); (4) Current 90 day forward exchange rate: $1.98/£ Is the Pound trading at a premium or discount?

Solution and Explanation:

Assume US Investor need 1000 Pound after 90 days:

Option 1: Forward Option:1000 pound = 1000 multiply with 1.98 = $1980

Option 2: Invest in UK:

Need 1000 pound after 90 days

so, Invest in UK pound today 1000 divide by 1.04 = 961.5385

to get 961.5385 today he need to pay = 961.5385 multiply with $2 (Current Spot Rate)

= $1923.077

Option 3 : Invest in US:

Need 1000 Pound after 90 days

so forward Exchange rate 1.98 he need 1000 pound * 1.98 = 1980 $ after 90 days

so invest today 1980/1.02 = $1941.176

Advise: Option 2 is best, Invest in UK Bonds