Reference no: EM132398353

Alecia's firm has 2 million pounds that her firm wants to be in dollars by the end of the year.  Assume that expected inflation in England is 8% and expected inflation is 2% in the U.S. 

• If the real interest rate in both countries is equal to 1% what will be the one year yield on a government bond issued by England and a one year government bond issued by the U.S. Treasury? Explain and show your work.
• Assume that the spot rate is equal to $1.41 for one pound.  What will be the one year forward rate if traders have taken into account the expected inflation differential between the two countries?  Explain and show all your work.
• Show that at the forward rate you have calculated in part (b) that the return the firm can earn is the same whether Alecia converts the pounds to dollars today and invests in the U.S. or whether she holds the pounds for one year and converts at the forward rate.
• Assume that Alecia has her own model to forecast inflation in both countries and her model predicts that inflation in England will be equal to 3% while inflation in the U.S. will stay at 2%.  Show that if Alecia is correct that she can make money for her firm.  
• Assume Alecia also manages her own portfolio.  If Alecia believes in her forecast she can make huge sums of money by buying or selling forwards on dollars at the forward rate you have calculated in part (b).  What should she do? Explain all your work.