Assume that the treasurer of a company has an extra cash reserve of $1,000,000 to invest for six months. The six-month interest rate is 8% per year in the U.S. and 6% per year in Germany. At present, the spot exchange rate is DM1.60 per dollar and the six-month forward exchange rate is DM1.56 per dollar. The treasurer of a company does not want to bear any exchange risk. Where should he or she invest to maximize the return?

Solution:  The market conditions are summarized as follows:

   I_$ = 4%; i_DM = 3%; S = DM1.60/$; F = DM1.56/$.

If $1,000,000 is invested in the U.S., the maturity value in six months will be

        $1,040,000 = $1,000,000 (1 + .04).

Otherwise, $1,000,000 can be transformed into DM and invested at the German interest rate, along with the DM maturity value sold forward. In this example the dollar maturity value will be

        $1,056,410 = ($1,000,000 x 1.60)(1 + .03)(1/1.56)

Obviously, it is better to invest $1,000,000 in Germany with exchange risk hedging.