Suppose that you dont have any money Assume that the spot ex

Suppose that you don’t have any money. Assume that the spot exchange rate between the U.S. dollar and euro is S₀ ($1.08 /€) , and the six-month U.S. and EU riskfree interest rates are 2% and 6% respectively (both rates are continuously compounding). Assume that the six month forward exchange rate is F₀^{6 Month} ($1.00/€).

Facts & Formulas:_______________________________________________________________

a) How can you make a profit from this situation? Please clearly explain your strategy and show your calculations. (2 points) ________________________________________________________________________ ________________________________________________________________________

b) At what six-month forward rate profits are zero? (2 points)

Solution

Answer:

So,

Int Rate for US = 2%

Int Rate for EU Market = 6%

Six Month Forward Rate should be = 1.08 * (e^1.01/e^1.03)

= $ 1.0586/Euro

Since Six Month Forward Rate is $1.00/Euro which is available at a discount , we should borrow Euro and purchase $ now.

Borrow Euro 100,000.

So Outflow after 6 months = 100000*e^1.03

= 103,045

Buy $ now, So $ Inflow now = 100000*1.08

= $ 108,000

Invest in $ market,

So Inflow After 6 month = 108000* e^1.01

= 109,085

Convert $ in Euro using 6 month forward rate = $1.00/Euro * 109085

= Euro 109085

Profit = 109085- 103045

= Euro 6,040

B.

6 month for Rate should be = $ 1.0586 /Euro