Suppose you observe a spot exchange rate of $2.00/£.If interest rates are 5 percent APR in the U.S.and 2 percent APR in the U.K.,what is the no-arbitrage 1-year forward rate?
A)£2.0588/$
B)$2.0588/£
C)£1.9429/$
D)$1.9429/£

Question

Quizplus · Accepted Answer

To calculate the no-arbitrage forward rate, we need to use the Interest Rate Parity (IRP) equation:

F = S × (1 + r foreign ) / (1 + r domestic )

Where:
F = the no-arbitrage forward rate
S = the spot rate
r foreign = the foreign interest rate
r domestic = the domestic interest rate

Plugging in the given values, we get:

F = 2.00 × (1 + 0.02) / (1 + 0.05) = 2.0588

Since we want the forward rate for pounds per dollar, we take the reciprocal of 2.0588 and get:

1 / 2.0588 ≈ 0.4858

Therefore, the no-arbitrage 1-year forward rate is $2.0588/£.

Suppose You Observe a Spot Exchange Rate of $2