Question

Suppose that the one-year interest rate is 5.0 percent in the United States; the spot exchange

rate is $1.20/€; and the one-year forward exchange rate is $1.16/€. What must the one-year

interest rate be in the euro zone to avoid arbitrage?

A) 5.0%

B) 6.09%

C) 8.62%

D) none of the options

Answer 1

The interest rate for the euro zone to avoid arbitrage has to be C) 8.62%

Step-by-step explanation:

Hi, we need to solve for r(eur) the following equation in order to find an interest rate that will avoid arbitrage.

`Forward=Spot((1+r(usd))/(1+r(eur)) )`

That is:

`1.16 =1.20 (\frac{1+0.05} {1+r(eur)} )`

`(1+r(eur)) =\frac{1.20} {1.16} (1+0.05)`

`r(eur)=(1.20)/(1.16)(1+0.05)-1`

`r(eur)=0.0862`

So, the euro zone rate to avoid arbitrage is 8.62%, which is option C)

Best of luck.