Current Exchange Rate for the US Dollar - Essay Example

This amount translates into US$ 13000. If on the other hand, I choose to take the money to the US banks, then I will earn interest of (2/100*12500). This gives an interest of US$ 2500 for that particular year. The total amount that I would have will then be US$ 15000. The above calculations are based on the fact that Irish banks give a 4% interest rate per one-year CD while the US banks give a 2% interest per one-year CD. If I choose to keep my winning and cash it into US dollars one year from today, the period during which the exchange rate changes from US$1 for .80 Euro, to US$1 to €.85, then my overall winning will increase greatly. During that year the amount will have increased by 40 000 Euro and will be 1040000 Euro. This will then be translated into US$12235.294. Given these calculations, I would rather take my winning to the USA than leave then in Ireland.

Covered interest arbitrage refers to a trading strategy in which an investor takes advantage of the difference in interest rates between two countries. They use forward contracts to shield themselves from risks that may arise as a result of exchange rate differences. An investor can choose to use a forward premium to take advantage of a forward premium to earn a profit that is free from risk because of the discrepancies in the interest rates of the two countries involved (Madura, 2007). This condition is possible because the parity in interest rates is not always constant. Three economists Robert, Dunn, and John have noted that in some cases financial markets give data that proves not to be consistent with the parity in interest rates (Dunn et al., 2004). They further observed that instances, where significant arbitrage profit of the covered interest appeared feasible, were, in most cases a result of assets having deferent risk perceptions, double taxation risks as well as cumbersome controls on foreign exchange.

Purchasing power parity refers to the component of economic theories that determines the values of different currencies relative to each other (Frenkel et al., 1981). This is based on the assumption that one would require the same amount in one currency to buy another currency and proceed to buy a given amount of goods as to buying directly in the original currency. Under this assumption, the number of US dollars required to directly buy a given quantity of goods would be the same if the dollars were first converted to Euros before buying the number of goods in question. The purchasing power parity concept enables investors to determine the exchange rate required to result in equivalence of the purchasing power between two currencies. In case of inflation in a country, the currency of that country depreciated. This means that the currency has a lower value relative to other currencies. As a result, more of that currency can be converted into a smaller number of other currencies. The purchasing power of that currency reduces with increasing inflation.

In the year in which my lottery has invested the value of the Euro reduced. This is an indication of inflation in Ireland. As I have noted, If I chose to keep my winning and cash it into US dollars one year from today, the period during which the exchange rate changes from US$1 for .80 Euro, to US$1 to €.85, then my overall winning will reduce greatly. During that year the amount will have increased by 40 000 Euro and will be 1040000 Euro. This will then be translated into US$12235.294 as opposed to US$ 1300 when the interest rate was US$1 for .80 euros. Given these calculations, I would rather take my winning to the USA than leave then in Ireland. For this reason, we can infer that over the year in which I invested my winnings in Ireland, the country experienced inflation. Due to this inflation, the purchasing power of Euros was greatly reduced as compared to that of US dollars. Purchasing power parity can therefore be defined as the component of economic theories that determines the values of different currencies relative to each other. Under this assumption, the number of US dollars required to directly buy a given quantity of goods would be the same if the dollars were first converted to Euros before buying the number of goods in question. Inflation, however, affects the reality of this assumption.