The replication method identifies the price of a USD/GBP forward rate as a function of
A) The expected future USD/GBP exchange rate, the GBP interest rates, and the USD interest rates
B) The spot USD/GBP exchange rate and the volatility of the spot USD/GBP exchange rate
C) The spot USD/GBP exchange rate, the GBP interest rates, and the USD interest rates
D) Only the spot USD/GBP exchange rate

Question

The replication method identifies the price of a USD/GBP forward rate as a function of 
A) The expected future USD/GBP exchange rate, the GBP interest rates, and the USD interest rates
B) The spot USD/GBP exchange rate and the volatility of the spot USD/GBP exchange rate
C) The spot USD/GBP exchange rate, the GBP interest rates, and the USD interest rates
D) Only the spot USD/GBP exchange rate

Quizplus · Accepted Answer

The replication method requires the price of a forward contract to be a function of certain variables that include the spot exchange rate, interest rates, and the length of the contract. Therefore, in this question, the price of a USD/GBP forward rate is identified as a function of the spot USD/GBP exchange rate, GBP interest rates, and USD interest rates. Option A is incorrect as it only includes the expected future exchange rate, which is not sufficient to determine the price of a forward contract using the replication method. Option B is also incorrect as it only includes the spot exchange rate and its volatility, which is not sufficient to determine the price of a forward contract. Option D is incorrect as it only includes one variable, whereas the replication method requires multiple variables to be considered.

The Replication Method Identifies the Price of a USD/GBP Forward