If F/S

Question

If F/S < (1 + i)/(1 + i*)(where exchange rates are quoted in $/£,i is the interest rate in the U.S.and i* is the interest rate in the U.K.),which of the following is true?

Quizplus · Accepted Answer

According to the given inequality, F/S is less than [(1 + i)/(1 + i*)]. This means that the forward exchange rate is lower than the expected future spot exchange rate. Therefore, an arbitrage opportunity exists where an investor can sell £1 forward and simultaneously buy £1 in the spot market. To do so, the investor will borrow pounds (since interest rate on this currency is i*) and convert them into dollars at the spot rate S. Then, the investor will convert these dollars into pounds at the forward rate F and use them to repay the loan with interest. The profit will be [F/S - (1 + i*)/(1 + i)] per pound borrowed, which will be positive as long as F/S is lower than [(1 + i)/(1 + i*)]. Therefore, the correct answer is C.

If F/S < (1 + I)/(1 + I*)(where Exchange Rates