Question
Suppose today's dollar/ British pound exchange rate is 0.78/$, that is, you need 0.78British pound (BGP) to buy one US dollar (USD). Suppose the one-year
Suppose today's dollar/ British pound exchange rate is 0.78/$, that is, you need 0.78British pound (BGP) to buy one US dollar (USD). Suppose the one-year continuous compounded USD denominated interest rate is 2.0%, and the one year continuously compounded BGP denominated interest rate is 0.1%.
a. If the one year forward exchange rate is 0.77/$, explain what transactions you could use (specifying the currency of denomination) to make some money (what is the amount of money one can make?) with zero initial investment and without risk.
b. If there are proportional transaction costs of 1% for any trade involving the exchange, is there still such arbitrage opportunity? Justify your answer.
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