The spot exchange rate E = $0.95 US / FOREX. The U.S. interest rate is 2% per an

Question

The spot exchange rate E = $0.95 US / FOREX. The U.S. interest rate is 2% per annum. The interest rate in the foreign country is 3% per annum. A futures contract for delivery of 1 million units of the foreign currency one year from today is trading now at F = $0.92 US / FOREX.

Which of the following is true? An arbitrage strategy

a. Doesn’t exist

b. Would involve buying the futures contract and borrowing in the foreign currency

c. Would involve selling the futures contract and borrowing in U.S. dollars.

Show work to support answer.

Explanation / Answer

Correct option is > b. Would involve buying the futures contract and borrowing in the foreign currency

Calculate forward rate:

Forward rate calculated = Spot rate x (1+US rate)/(1+Foreign country rate)

Forward rate calculated = 0.95 x (1+2%)/(1+3%)

Forward rate calculated = $0.94/FOREX

.

Given Forward rate = $0.92 US / FOREX

Hence, present forward rate is trading lower which should reach to calculated forward rate, therefore buy futures contract and borrow in foreign currency would lead in sure shot profit.

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