Question

In early 2012, the spot exchange rate between the Swiss Franc and U.S. dollar was 1.0404 ($ per franc). Interest rates in the U.S. and Switzerland were 1.35% and 1.10% per annum, respectively, with continuous compounding. The three-month forward exchange rate was 1.0300 ($ per franc). What arbitrage strategy was possible? How does your answer change if the exchange rate is 1.0500 ($ per franc).

Answer 1

As per Interest Rate Parity,

Theoretical Forward Rate $/Sfr = Spot $/Sfr*(1+Interest Rate on $)/(1+Interest Rate on Swiss Franc)

= 1.0404*[1+(0.0135/4)]/[1+(0.011/4)]

= 1.0410

i) If Forward Rate is 1.0300

Actual Forward Rate < Theoretical Forward Rate

As the Rates are different, there is a Covered Interest Arbitrage Opportunity.

Actual Forward Rate of Sfr is Undervalued

To make an Arbitrage Gain, Sell Sfr in Spot and Buy in Forward

ii) If Forward Rate is 1.0500

Actual Forward Rate > Theoretical Forward Rate

As the Rates are different, there is a Covered Interest Arbitrage Opportunity.

Actual Forward Rate of Sfr is Overvalued

To make an Arbitrage Gain, Buy Sfr in Spot and Sell in Forward