The spot exchange rate for the British pound is 0.5 pounds/dollar. The one-year interest rate in Australia is 6% and the one-year interest rate in Britain is 5%. Based on these rates, what one-year forward exchange rate is consistent with the absence of arbitrage?

Question

Quizplus · Accepted Answer

The forward exchange rate that prevents arbitrage can be calculated using the interest rate parity formula, which is F = S * (1 + i_d) / (1 + i_f), where F is the forward exchange rate, S is the spot exchange rate, i_d is the domestic interest rate, and i_f is the foreign interest rate. Here, assuming Britain is domestic and Australia is foreign, S = 0.5, i_d = 5% or 0.05, and i_f = 6% or 0.06. Plugging these into the formula gives F = 0.5 * (1 + 0.05) / (1 + 0.06) = 0.5 * 1.05 / 1.06 = 0.495.

The Spot Exchange Rate for the British Pound Is 0