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A portfolio manager based in the United Kingdom is planning to invest in U.S. bonds with a maturity of one year. Assume that the ratio of the price levels of a typical consumption basket in the United Kingdom versus the United States is 1.4 to 1. The current exchange rate is £0.73 per dollar. The one-year interest rate is 1.80 percent in the United States and 4.20 percent in the United Kingdom. Assume that inflation rates are fully predictable, and expected inflation over the next year is 1.6 percent in the United States and 3.80 percent in the United Kingdom.
Assuming that real exchange rates remain constant, calculate the real exchange rate, the expected exchange rate in one year, and the expected return over one year on the U.S. bonds in pounds.
Now assume that the inflation rate over the one-year period has been 1.6 percent in the United States and 3.80 percent in the United Kingdom. Further, assume that the exchange rate at the end of one year is £0.73 per dollar. Calculate the real exchange rate at the end of one year. What is the return on the U.S. bond investment now? Is the return on the U.S. bond the same as in part (a)? Explain
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