Question

On September 30, 2007, the following were the prices for the Euro FX Contract

Months             3                 6                     9                12          18

          Cash    Dec. 07     March 08      June 08     Sep. 08   Dec. 08

€/$ TBD      1.4293       1.4303           1.4308      1.4311   1.4311

The 3-month U.S. Treasury offered a yield of 3.64% and the 6-month offered 3.91%. The price of USD to EUR was 0.7006€. The yield on the 3-month German federal security was 3.88%.

     1. What was the spot rate?

    2. If there are no market imperfections, was there an arbitrage opportunity here? If so, how would you have exploited it?

   3. What is the most likely reason why you could not get rich?

Answer 1

1) Using IRP:       F=S*(1+i_f) /(1+i_d)

                        =1.4293/S= 1.0364/1.0388

                        =S= 1.4326 E/$

2) Actual spot rate prevailing in the market is 1/0.7006= 1.4273 E/$. Therefore, we can say Euro is undervalued (1.4273 < 1.4326). Hence, we will borrow for 3 months at the treasury rate of 3.64 % and invest in German government bond at 3.88%.

3) The most likely reason might be:

• Inability to borrow at the treasury rate because of your credit profile.
• Transaction costs to carry out the trade.