The one-year interest rates in UK and USA are 6% and 4% per annum with continuous compounding, respectively. The spot exchange rate between British pounds and US dollars is 1.6479 USD per GBP. A financial institution offers a currency forward contract with an one-year forward exchange rate at 1.571 USD per GBP. An arbitrageur can make risk-free profits by following the strategy:

• Borrow British pounds, convert them to US dollars, invest them at 4% pa and enter a short position in the forward contract

• Borrow British pounds, convert them to US dollars, invest them at 4% pa and enter a long position in the forward contract

• Borrow US dollars, convert them to British pounds, invest them at 6% pa and enter a short position in the forward contract

• Borrow US dollars, convert them to British pounds, invest them at 6% pa and enter a long position in the forward contract

• Arbitrage is not possible

Answer rating: 100% (QA)

Interest rates UK 6 pa US 4 pa Spot exchange rate 1 GBP 16479 USD Forward exchange ... View the full answer