A currency dealer has good credit and can borrow either $1,000,000 or €800,000 for one year.The one-year interest rate in the U.S.is i_$ = 2% and in the euro zone the one-year interest rate is i_€ = 6%.The one-year forward exchange rate is $1.20 = €1.00; what must the spot rate be to eliminate arbitrage opportunities?

Question

Quizplus · Accepted Answer

The correct answer is A because the spot rate must be $1.2471 = €1.00 to eliminate arbitrage opportunities. This is because the currency dealer can borrow $1,000,000 at 2% interest and convert it to €800,000 at the spot rate of $1.2471 = €1.00. The dealer can then invest the €800,000 in the euro zone at 6% interest and earn a profit of €48,000.

A Currency Dealer Has Good Credit and Can Borrow Either