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  3. problem: *liberia interest rate = 7% *u.s. interes

PROBLEM: *Liberia Interest rate = 7% *U.S. Interest rate = 2% Spot exchange rate between...

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Accounting

PROBLEM:

*Liberia Interest rate = 7%

*U.S. Interest rate = 2%

Spot exchange rate between U.S. Dollar and LRD is 0.5USD per LRD

Spot exchange rate after 1 year between U.S. Dollar and LRD is 0.47USD per LRD

If a person invest 1 LRD now and buy dollars of that, she will get 0.5 dollar. Dollar will earn 2% rate of interest which will make it 0.5 * 1.02 = 0.51 dollar after one year.

This 0.51 dollar in one year can be converted back to Liberian currency which will give 0.51 / 0.47 = 1.085 LRD which is actually 8.5% growth while the rate of interest in Liberia is 7%. Arbitrage gives 1.5% more in trading between currencies. So, there exist a arbitrage opportunity.

QUESTION: But the strategy is not an arbitrage? (because they are investing the LRD?)

Answer & Explanation Solved by verified expert
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