Will an arbitrageur facing the following prices be able to make money? $\begin{array}{rcccccc}
\hline & \text { Bid } & \text { Ask } & & \text { Borrowing } & \text { Lending } \
F_{0}(\$ / €) & \$ 1.40-€ 1.00 & \$ 1.43-€ 1.00 & & i \$ 4.20 \% \mathrm{APR} & 4.10 \% \mathrm{APR} \
F_{36}(\$) & \$ 1.44-€ 1.00 & \$ 1.49-€ 1.00 & & i € 3.65 \% \mathrm{APR} & 3.50 \% \mathrm{APR}
\end{array}$
A)Yes,borrow €1,000,000 at 3.65 percent; trade for $ at the bid spot rate $1.40 = €1.00; invest at 4.1 percent; hedge this with a long position in a forward contract.
B)Yes,borrow $1,000,000 at 4.2 percent; trade for € at the spot ask exchange rate $1.43 = €1.00; invest €699,300.70 at 3.5 percent; hedge this by going SHORT in forward (agree to sell € @ BID price of $1.44/€ in one year).Cash flow in 1 year $237.76.
C)No; the transactions costs are too high.
D)none of the options

Question

Will an arbitrageur facing the following prices be able to make money? $\begin{array}{rcccccc}
\hline & \text { Bid } & \text { Ask } & & \text { Borrowing } & \text { Lending } \
F_{0}(\$ / €) & \$ 1.40-€ 1.00 & \$ 1.43-€ 1.00 & & i \$ 4.20 \% \mathrm{APR} & 4.10 \% \mathrm{APR} \
F_{36}(\$) & \$ 1.44-€ 1.00 & \$ 1.49-€ 1.00 & & i €  3.65 \% \mathrm{APR} & 3.50 \% \mathrm{APR}
\end{array}$
A)Yes,borrow €1,000,000 at 3.65 percent; trade for $ at the bid spot rate $1.40 = €1.00; invest at 4.1 percent; hedge this with a long position in a forward contract.
B)Yes,borrow $1,000,000 at 4.2 percent; trade for € at the spot ask exchange rate $1.43 = €1.00; invest €699,300.70 at 3.5 percent; hedge this by going SHORT in forward (agree to sell € @ BID price of $1.44/€ in one year).Cash flow in 1 year $237.76.
C)No; the transactions costs are too high.
D)none of the options

Quizplus · Accepted Answer

The arbitrageur can borrow $1,000,000 at 4.2% and exchange it for €699,300.70 at the spot ask exchange rate of $1.43 = €1.00. They can invest this amount at 3.5% and hedge the investment by going SHORT in a forward contract to sell € at the BID price of $1.44/€. The cash flow in one year will be:

€699,300.70 x (1 + 3.5%) = €723,768.91
Sell €723,768.91 at $1.44/€ = $1,041,439.84
Repay the $1,000,000 loan + interest = $1,000,000 x (1 + 4.2%) = $1,042,000
Cash flow = $1,041,439.84 - $1,042,000 = -$560.16

This gives a negative cash flow of $560.16, which means the arbitrageur would have to pay this amount out of pocket. Therefore, there is no arbitrage opportunity. Option A is incorrect because it suggests borrowing euros at a higher rate than investing dollars, which would result in a negative cash flow. Option C is incorrect because there is no mention of transaction costs. Option D is incorrect because option B provides a specific strategy that can be followed.

Will an Arbitrageur Facing the Following Prices Be Able to Make