Suppose that the one-year interest rate is 5.0 percent in the United States and 3.5 percent in Germany, and that the spot exchange rate is $1.12/€ and the one-year forward exchange rate, is $1.16/€. Assume that an arbitrageur can borrow up to $1,000,000.

Question

Quizplus · Accepted Answer

According to interest rate parity, the forward exchange rate should be calculated using the interest rate differential between the two countries. In this scenario, the interest rate differential is (5.0% - 3.5%) = 1.5%. However, the one-year forward rate is $1.16/€, which implies an interest rate differential of (1.16/1.12 - 1) * 100% = 3.57%. This is higher than the actual interest rate differential, so there is an arbitrage opportunity. The arbitrageur can borrow $1,000,000 in the US, convert it to €892,857 at the spot rate ($1,000,000 / $1.12/€), invest it in Germany for one year at 3.5%, and then convert it back to US dollars at the higher one-year forward rate ($1,000,000 / $1.16/€ * 1.035) = $951,724. This results in a profit of $951,724 - $1,000,000 = -$48,276, which is the cost of the arbitrage.

Suppose That the One-Year Interest Rate Is 5