The following exchange and interest rate quotations in 1998 were observed: Euroc

Question

The following exchange and interest rate quotations in 1998 were observed:

Eurocurrency rates

Exchange rate per $

90-days (% annum)

(Discretely-compounded)

Spot

90-day

forward

Bid:

Ask:

$

15 5/8

16

DM

7 7/8

8 1/4

£

12 1/4

13

DM

1.881

1.843

£

.4961

.4902

DM

1.801

1.773

£

.4937

.4889

An arbitrage profit can be obtained by

a)  borrowing pounds and lending dollars

b)  borrowing dollars and lending DM

c)  borrowing DM and lending pounds

d)  there are no arbitrage opportunities

Eurocurrency rates

Exchange rate per $

90-days (% annum)

(Discretely-compounded)

Spot

90-day

forward

Bid:

Ask:

$

15 5/8

16

DM

7 7/8

8 1/4

£

12 1/4

13

DM

1.881

1.843

£

.4961

.4902

DM

1.801

1.773

£

.4937

.4889

Explanation / Answer

Answer is option(a) borrowing pounds and lending dollars.

An arbitrage profit can be obtained by-

Interest rate and parity theory

Interest Rate Parity (IRP) is a theory in which the differential between the interest rates of two countries remains equal to the differential calculated by using the forward exchange rate and the spot exchange rate techniques. Interest rate parity connects interest, spot exchange, and foreign exchange rates. It plays a crucial role in Forex markets.

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