Solution-Expect the dollar to depreciate against the pound

Expect the dollar to depreciate against the pound

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Reference no: EM131221385

An investor believes the market has systematically over-valued the dollar, and proceeds to short dollars (betting the dollar will fall in value by enough, i.e.,that E will rise by enough). His investment scheme is as follows:

1. Borrow E_t dollars at date t. Promise to repay them at date t + 1, with interest at rate i_US.

2. Bet the price of dollars will fall enough, i.e., bet that E_t+1 > E_tby enough:

Buy 1 pound for Et dollars at date t
Earn interest, ending up with 1 + i_B pounds
Buy dollars at date t + 1, obtaining E_t+1(1 + i_B) dollars for your 1 + i_Bpounds
Repay the loan. With interest, the repayment is E_t(1 + i_US) dollars

a.) What is the condition for positive profits?

b.) Is it sufficient that E_t+1 > E_t? Why or why not?

c.) Suppose markets expect the dollar to depreciate against the pound. In order to make a profit, what must happen to E relative to market expectations?

Reference no: EM131221385

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Expect the dollar to depreciate against the pound

Reference no: EM131221385

Reference no: EM131221385

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