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. He can then invest the €800,000 at 6% interest and convert it back to $1,024,710 at the forward rate. This would give him a profit of $24,710. However, if the spot rate is not $1.2471 = €1.00, then the currency dealer will not be able to make a profit from this arbitrage opportunity.

A Currency Dealer Has Good Credit and Can Borrow Either