Question

Assume the following information: Swiss one-year interest rate = 8%, U.S. one-year interest rate = 4%, Franc spot rate = 0.11 USD/CHF, Franc forward rate = 0.08 USD/CHF. If interest rate parity exists, how do you take advantage of this opportunity? Explain.

Answer 1

When Interest rate parity exists, the following formula exists:

1+Domestic rate=(Forward rate/spot rate)(1+foreign rate)

Here, let us assume that Swiss is home country and US is the foreign country. The forward rate if interest rate parity exists:

1+0.08=(F/0.11)(1+0.04).

It gives the forward rate Franc=0.11 USD/CHF.

But given forward rate is 0.08 USD/Franc. Hence, arbitrage opportunities exist. To take advantage, we must borrow swiss franc at 8% for 3 months and buy the dollars in spot market and invest the dollars at 4% for 3 months. After 3 months, avail the arbitrage.