Problem 2 (28 points)

You work as a trader for the arbitrage desk at Goldman Sachs, monitoring spot and futures foreign exchange rates. At 9am Eastern time you observe the following market prices and rates. The spot exchange rate between US$ and Canadian dollar is $1.1100/C$, while futures price of Canadian dollar for the contract maturing in 6 months is $1.0400/C$. The US 6-month interest rate is 6.5% per annum, while Canadian 6-month interest rate is 3.5% per annum. Both interest rates are based on continuous compounding.

(a)What is the no-arbitrage futures exchange rate?(8 pts)

(b)Given your answer in part (a) and data provided, describe in detail the arbitrage strategy that will earn profit and calculate your profit, assuming that you can lend or borrow 1000 units of a currency. (14 pts)

Now assume that many other traders can follow the arbitrage strategy you described in part b.

(c)Will US$/C$ futures exchange rate go up or down? (3 pts)

(d)Will US$/C$ spot exchange rate go up or down? (3 pts)