A Japanese electronics manufacturer is contemplating investing $1 billion (with all of the investment to be made at the outset) in a 3-year investment project in the U.S. The Japanese company is well known in world capital markets and is universally regarded as quite safe. To help finance the project, the company believes it could issue 3-year zero coupon bonds in the U.S. at a yield that would be very close to the current 3-year U.S. Treasury rate of 4%. Alternatively, the company could issue equivalent 3-year zero coupon debt in Japan at an interest rate of 2%. Assume for simplicity that both rates are annually compounded rates. The current spot exchange rate is 89.6 /$.

What do you expect the /$ exchange rate to be 3 years from now? How does your forecast help you explain the current differential between interest rates in the U.S. and Japan? What would be the effective rate of issuing bonds in Japan, if your forecast is correct?

Given the prevailing interest rates and spot exchange rate, what do you think is the current three-year forward /$ exchange rate?