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Suppose the spot exchange rate between the United States and France is $1.28/. The continuously compounded interest rate in the U.S. is 5%, while the
Suppose the spot exchange rate between the United States and France is $1.28/. The continuously compounded interest rate in the U.S. is 5%, while the continuously compounded euro-denominated interest rate is 3%. Suppose you observe a 12-month forward exchange rate of $1.14/. What transactions could you undertake to make money with zero initial investment and no risk?
a. | Borrow euros, convert to U.S. dollars, and invest in a U.S. dollar-denominated bill today. After 12 months, convert back to euros at $1.14/ and pay off the loan. | |
b. | No arbitrage is possible under these conditions. | |
c. | Borrow U.S. dollars, convert to euros, and invest in a euro-denominated bill today. After 12 months, convert back to U.S. dollars at $1.14/ and pay off the loan.. | |
d. | Borrow U.S. dollars and invest in a U.S. dollar-denominated bill today. After 12 months, pay off the loan and convert the excess funds to euros at $1.14/. | |
e. | Borrow euros and invest in a euro-denominated bill today. After 12 months, pay off the loan and convert the excess funds to U.S. dollars at $1.14/. |
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