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Suppose the spot and one-year forward exchange rates on the New Zealand dollar are NZD1.055/AUD and NZD1.110/AUD, respectively. The risk-free rate is 5 percent per

Suppose the spot and one-year forward exchange rates on the New Zealand dollar are NZD1.055/AUD and NZD1.110/AUD, respectively. The risk-free rate is 5 percent per year in New Zealand and 3 percent per year in Australia.

Required:

(a) How can an investor go about exploiting the arbitrage opportunity? Show all necessary calculations. (12 marks)

(b) What must the one-year and two-year forward exchange rates be to prevent any arbitrage? (3 marks)

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