Question

3. The spot exchange rate is $2/fc. The foreign interest rate is 8% and the U.S. rate is 4%. If the futures price of fc1 is 2.05 is there an arbitrage opportunity? If yes, would you go long or short in futures on the foreign currency?

  A.       No

B.       Yes, long

C.       Yes, short

D.       Yes, but I will take no position in futures.

Answer 1

According tp Interest Rate Parity the futures price should be= Spot Price x (1+Dollar Interest Rate)/(1+FC Interest Rate)

Therefore Future exchange Rate = 2 * (1+0.04)/(1+0.08)

Futures price = $1.92 / fc

Now since, the given Futures price is $ 2.05 / fc therefore there exists an arbitrage opportunity.

Given the futures price of $ 2.05 / fc and the should be future price of $1.92 / fc, therefore in order to earn the arbitrage one should short the futures contract as the should be price is lower than the given price

Therefore the correct answer is C.