The continuously-compounded forward-interest-rate curve for euros lies above that for dollars up to five years in maturity and then crosses below the dollar forward curve.The current spot exchange rate is $1.50/€.What is the most valid statement of the following?
A)The forward exchange rate ($/€)will always be less than 1.50 for all maturities up to five years.
B)The forward exchange rate ($/€)will always be greater than 1.50 for all maturities greater than five years.
C)The forward exchange rate ($/€)will always be less than 1.5 for all maturities greater than five years.
D)There is insufficient information to be able to make any definitive statements about the forward exchange rate.

Question

Quizplus · Accepted Answer

The forward exchange rate depends on the spot exchange rate and the zero-coupon rates in each currency for the specified maturity of the contract.Up to five years,the zero-coupon rates depend on the accumulated forward rates,and the euro zero-coupon rate will be always greater than that of the dollar-the currency at the higher interest rate will trade at a discount in the forward exchange market,i.e. ,the forward FX rate will be less than 1.50.
One might be misled into thinking that since the dollar forward rates are higher than that of the euro after five years that the exchange rate should be greater than 1.5 for maturities greater than five years.However,note that,just because the forward rates in dollars are greater than those in euros after five years,does not imply that the dollar zero-coupon rates are also greater than that of euros after five years.Indeed,it takes some time before the accumulated forward rates (i.e. ,zero-coupon rates)for dollars will surpass that of euros.Hence,it is not guaranteed that the forward exchange rate will exceed 1.50 right after five years in maturity.

The Continuously-Compounded Forward-Interest-Rate Curve for Euros Lies Above That for Dollars