principle of arbitrage
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Suppose the spot exchange rate is $2.00 per euro and that the annual interest rate on one-year government bond is 10 percent in the U.S. and 8 percent in Germany.
a. If you expect the spot price of the euro to be $2.00 in one year, where will you
invest? Explain
b. In order for investors to be indifferent between the U.S. and German securities,
what would the one-year forward rate for euros have to be?
c. Given the initial spot rate at $2.00 per euro, interest rates as given above, and
the principle of arbitrage, would the euro be expected to appreciate or depreciate?
Explain.
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Solution Summary
Predict Euro patterns in this post.
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Economics:
Suppose the spot exchange rate is $2.00 per euro and that the annual interest rate on one-year government bond is 10 percent in the U.S. and 8 percent in Germany.
a. If you expect the spot price of the euro to be $2.00 in one year, where will you
invest? Explain
Solution:
$2.00 = 1 euro
So, $1 = ½ euro
For example, if I invest $100 in U.S, then I will get,
$100 + $100 * 10% ...
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