Forward Market and No Arbitrage Opportunities
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A). The treasurer of a German firm has ?5 million to invest for three months. The annual interest rate in the Germany is 4 percent: the interest rate in the United Kingdom is 2 percent. The spot rate of exchange is ?1.1/£ and the three-month forward rate is ?1.2/£. Ignoring transactions costs, in which country would the treasurer want to invest the company's capital using the forward market? Explain your answer.
B) Suppose the spot rate of exchange between Germany and the UK at time t is $1.50/£. If the interest rate in the U.S. is 13 percent and it is 8 percent in the UK, what would you expect the one-year forward rate to be if no immediate arbitrage opportunities exist?
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The solution demonstrates the use of forward contract.
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A). The treasurer of a German firm has ?5 million to invest for three months. The annual interest rate in the Germany is 4 percent: the interest rate in the United Kingdom is 2 percent. The spot rate of exchange is ?1.1/£ and the three-month forward rate is ?1.2/£. Ignoring transactions costs, in which country would the treasurer want to invest the company's capital using the forward market? Explain your answer.
According to interest rate parity condition since interest rate in Germany is higher, Pound should appreciate by interest rate differential ; approximately (4%-2%) x 3/12 = 0.50%
Forward Pound = 1.2 Euros/Pound
Spot Pound= 1.1 ...
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