Prob em You work as a trader for the arbitrage desk at RawTrade, exchange exchan

Question

Prob em You work as a trader for the arbitrage desk at RawTrade, exchange exchangeat ern time vouos he eioting spot and utures toreign the following market prices and rates. The spot price of Canadian in 6 months is $10400 CS The US 6-month interest rate is 6.5% ekchange rate between USS and Canadian dollar is S1.1100/CS, while forward price of dollar for the cont ract maturing per annum, while Canadian 6-month interest rate is 35% based on continuous compounding. are per annum. Both interest rates (a) What is the no-arbitrage futures exchange rate? (4 pts) (a) and data provided, deseribe in detail the arbitrage strategy at will earn profit and calculate your profit, assuming that you can lend or borrow 1000 (b) Given your answer in part th units of a currency. (12 pts)

Explanation / Answer

Using the interest rate parity, forward exchange rate can be calculated using the following formula:

Forward rate= Spot* [(1 + Id)/(1+If)]^n

Where,

Id domestic interest rate;
If is foreign intrest rate; and
n is number of time periods

Hence here :

No arbitrage Forward rate = 1.1100*e^[(1.065/1.035)]*(1/2)=1.1268

Since no arbitrage pegs forward rate at $1.1268/C$, we shall enter a forward contract to buy US dollar after 6 months
Hence borrow C$1000
Convert into USD at 1.1100= 1000*1.1100=$1,110
Invest at 3.5% componded continously = 1110*e^0.035/2=$1,129.60 after 6 months
After 6 months convert into C$ at forward rate = 1129.60/1.04=$1,086.15

Hnece we have a gain of C$86.15

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