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Question 39 of 40
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Suppose the futures price is below the price predicted by IRP. What steps would assure an arbitrage profit?
A. Go short in the spot market, go short in the futures contract.
B. Go long in the spot market, go long in the futures contract.
C. Go short in the spot market, go long in the futures contract.
D. Go long in the spot market, go short in the futures contract.
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At the same time, he enters into a forward contract to convert the money that he will get US Dollars at a forward rate of $1.58/€
After 1 year, he gets 625,000 * (1 + 4%) = €650,000
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No Arbitrage Forward rate = Spot Rate * (1 + RD)/ (1 + RF)
where Rp is the interest rate in the domestic country, in this case United States
RF is the interest rate in the foreign country, in this case Germany
Thus, using this formula, the no arbitrage forward rate should be = 1.6 * (1 + 2%)/ (1 + 4%) = 1.6 * 1.02 / 1.04 = $1.57 approximately However, the actual forward rate = $1.58/€Hence, there is an arbitrage opportunity.
Suppose an arbitrager borrows 1,000,000 in the United States at 2%.
Thus, after one year, he has to pay back 1,000,000 * (1 + 2%) = $1,020,000He converts 1,000,000 into Euros at the spot exchage rate of $1.60/€.Thus he gets 1,000,000/1.6 = €625,000
The arbitrager now invests this money in Germany at 4%.
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He converts this money into USD at the exchange rate of $1.58/€ (at which he entered th
Thus he gets 650,000 * 1.58 = $1,027,000
Amount he has to pay back = $1,000,000 * (1 + 2%) = $1,020,000
Net cash flow for the year through this arbitrage = $1,027,000 - $1,020,000 = $7,000
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