Question #14
Reading: Reading 5 Currency Exchange Rates - Understanding Equilibrium Value
PDF File: Reading 5 Currency Exchange Rates - Understanding Equilibrium Value.pdf
Page: 6
Status: Unattempted
Correct Answer: A
Question
If the one-year forward exchange rate is DC/FC 2 and the spot rate is DC/FC 1.9 when the foreign rate of return is 12% and the domestic return is 10%, which of the following statements would be most accurate?
Answer Choices:
A. Arbitrage is possible here, investors should borrow domestic, lend foreign
B. Arbitrage is possible here, investors should borrow foreign, lend domestic
C. The arbitrage possibilities cannot be determined with the data given
Explanation
Question 1: Is there an arbitrage opportunity?
If the result of the following formula (derived from rearranging the interest rate parity
condition) is not equal to 0, there is an arbitrage opportunity.
(1 + rdomestic) − [((1 + rforeign) × ForwardDC/FC)) / SpotDC/FC] = ?
Here, ( 1 + 0.10 ) − [ (( 1 + 0.12 ) × 2.0DC/FC) / 1.9DC/FC] = ( 1.10 − 1.18 ) = −0.08, which is not
equal to 0. Arbitrage opportunities exist.
Question 2: Borrow Domestic (local) or Foreign?
Here are some "rules" regarding where to start the arbitrage (where to borrow). These
rules only work if there are no transaction costs and only if the currency is quoted in
DC/FC terms.
Rule 1: If the sign on the result of question 1 is negative, borrow domestic. If the sign is
positive, borrow foreign. Here, the sign is negative, so borrow domestic.
Rule 2:
(rd − rf) < (Forward − Spot) / Spot then Borrow Domestic
(rd − rf) > (Forward − Spot) / Spot then Borrow Foreign
Here, borrow domestic:
(rd − rf) = ( 0.10 − 0.12 ) = −0.02 < (Forward − Spot) / Spot = ( 2.0DC/FC − 1.9DC/FC ) / 1.9DC/FC
= 0.05
−0.02 < 0.05
Summary: To take advantage of arbitrage opportunities, borrow domestic and lend
foreign.