Suppose you observe the spot euro at $1.50/€, the U. S. risk-free interest rate of 3.25% (continuously compounded), and the six month futures price of $1.50/€. Identify the correct implied European risk-free interst rate (select the closest answer).
A) -3.25%
B) -1.0%
C) 0.0%
D) 1.0%
E) 3.25%

Question

Quizplus · Accepted Answer

According to the cost-of-carry model, the futures price of a currency should be equal to the spot price times e^(r-d)t, where r is the domestic risk-free interest rate, d is the foreign risk-free interest rate, and t is the time to maturity. In this case, the futures price is the same as the spot price, indicating that the market expects the domestic and foreign interest rates to be equal over the next six months. Therefore, the implied European risk-free interest rate is 3.25%.

Suppose You Observe the Spot Euro at $1