The one-year forward exchange rate is Rupees 40/$.If the one-year interest rate in the United States is 4% and in India is 7%,what is the spot exchange rate so as to preclude arbitrage?

Question

Quizplus · Accepted Answer

The correct answer is A because the spot exchange rate should be such that there is no incentive for arbitrage. In this case, the spot exchange rate should be such that the cost of buying $1 in the spot market and investing it in the United States for one year is equal to the cost of buying $1 in the forward market and investing it in India for one year.The cost of buying $1 in the spot market and investing it in the United States for one year is:$1 * (1 + 0.04) = $1.04The cost of buying $1 in the forward market and investing it in India for one year is:$1 * (1 + 0.07) * (1 / 40) = $1.04Therefore, the spot exchange rate should be 40/1.04 = 38.88.

The One-Year Forward Exchange Rate Is Rupees 40