Question

Suppose you observe the following exchange rates: S($/SFr) = 0.85 (i.e. SFr 1 = $.85) The one-year forward rate is F₁($/SFr) = 0.935 (i.e. SFr 1 = $.935). The risk-free interest rate in the U.S. is 5% and in Switzerland it is 2%. How can a dollar-based investor make money?

Answer 1

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Answer:

A dollar-based investor can profit by borrowing dollars, exchanging them for Swiss francs, investing in Switzerland, and entering a one-year forward contract to sell Swiss francs for dollars.

Let’s assume we borrow $100 the rate of interest is 5% and convert the it in S Fr we will get 117.6471 (100/.85) and take the forward cover including forward cover premium is 0.935

At the end of one year we will earn 2% interest on 117.6471 i.e.2.3529

So in total we will get SFr= 120 (117.6471+2.3529)

Now we will have to convert back it into $ which will be $112.2 (120*.935)

So investor got (100+5-112.2) =$7.2 profit per 100 $ invested