Foreign Currency Arbitrage: The spot exchange rate for converting one US dollar into an FD...
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Foreign Currency Arbitrage: The spot exchange rate for converting one US dollar into an FD (a foreign dollar) is 8.32. The spot rate for converting one FD into USD is 0.1202 (= 1/8.32). A long FD forward contract obligates the holder to buy one FD in 9 months time at the rate 0.10 (USD per FD). Annual continuously compounded US interest rate is 1.0%. Annual continuously compounded foreign interest rate is 4.0%.
What is the fair forward price?
Given that fair forward price does not equal 0.10, propose a set of transactions that will produce an arbitrage. Fill in an arbitrage table with your numerical values assuming that ST = 0.09 at the end of nine months.
Repeat (b) but now provide the table assuming that ST = 0.13.
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