Assume interest rates in the US are at 1.5% per year, and interest rates in Isra

Question

Assume interest rates in the US are at 1.5% per year, and interest rates in Israel are at 6% per year, and that the shekel is trading at 4 sheckels/dollar. a. If the two-year forward rate on sheckels is 4.3 sheckels/dollar, do you want to invest in dollars or sheckels to maximize your returns for the next two years? b. How much would you make in arbitrage profits if you can borrow $10,000,000 or an equivalent amount of sheckels over this time period? c. What sheckel/dollar forward rate implies no arbitrage?

Explanation / Answer

Interest Rate Parity Theory (IRPT) is given by

[(1+Rh) / (1+Rf)]^n= F2 / So

Where

Rh - Interest rate in home country =6%

Rf - Interest rate in foreign country = 1.5%

F2 - 2 year forward rate = ?

S0 - spot rate = 4

n - no. of years until the date of foraward rate.

Here exchange rate is given by sheckels/dollar 4. That is Israel is the home country and US is the foreign country.

[(1.06) / (1.015)]^2= F2 / 4

F2/4 = 1.0906

F2 = 1.0906*4

F2 = 4.36

a. If the two-year forward rate on sheckels is 4.3 sheckels/dollar, do you want to invest in dollars or sheckels to maximize your returns for the next two years?

b. How much would you make in arbitrage profits if you can borrow $10,000,000 or an equivalent amount of sheckels over this time period?

*.25 = 1/4 and .23=1-.43

c. What sheckel/dollar forward rate implies no arbitrage?

In a no arbitrage case spot rate = forward rate = 4

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