a) Consider the Dollar as the home currency, given the following spot rates: - 1

Question

a) Consider the Dollar as the home currency, given the following spot rates: - 1 year US Treasury Bill interest rate = 2.20%
- 1 year French Government Bond interest rate = 3.8%
- US$ 1 = € 0.7733

what should the 1-year $ /€ forward exchange rate be?

b) Given the following information on spot rates:
$1 = SKr 7.3000 €1 = $ 1.2000

i) Show that the €/SKr exchange rate should be €1 = 8.76 SKr.

ii) Suppose you had $1,000,000 to invest, and you observed that €1 = SKr 8.6000. By exploiting the arbitrage opportunity, what is the profit (in %), that you can earn by pursuing the strategy (once)? Explain the steps you undertake.

iii) Outline the other factors that you would need to take into account before engaging into such a potential arbitrage opportunity.

Explanation / Answer

a) After one year value of $1=1*(1.022)=1.022 After one year value of € 0.7733=0.7733*(1.038)=0.802 So the relation between $ and € will be $1.022=€ 0.802 or $1=€ (0.802/1.022) or $1=€ 0.784 So the one year forward exchange rate will be   $1=€ 0.784 b) $1= SKr 7.3 €1= $1.2 or €1=SKr (1.2*7.3) [ by replacing $1=SKr 7.3 ] or €1 = SKr 8.76 c) The profit from arbitrage by investing €1=SKr 8.76-SKr8.60=SKr 0.16 or profit from $1.2 = SKr 0.16 or profit from $1000000= SKr (0.16/1.2)*1000000=SKr 133333.3 or profit from $1000000==$(133333.3/7.3) or profit from $1000000= $18264.84

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