Question

The following information are available in the foreign exchange and money market

A)Spot rate: €1=₹83.40−83.50
B)One year Euro interest rate: 0.25%−0.50%
C)One year INR interest rate: 6.40%−6.90%
Calculate one year forward rate for Euro. Suppose the one year forward rate between Euro and INR is €1=₹86.50−87.25. Is there any arbitrage opportunity? Show in detail.

Answer 1

The one year forward rate for Euro can be calculated using the interest rate parity formula. There is no arbitrage opportunity as the calculated forward rate is lower than the given forward rate.

Step-by-step explanation:

The one year forward rate for Euro can be calculated using the interest rate parity formula. According to interest rate parity, the forward rate for a currency is equal to the spot rate multiplied by the ratio of the interest rates between the two currencies.

In this case, the spot rate for Euro and INR is €1 = ₹83.40 − 83.50, and the one year interest rates are 0.25% − 0.50% for Euro and 6.40% − 6.90% for INR. The one year forward rate for Euro is calculated as follows:

Forward rate = Spot rate × (1 + Euro interest rate) / (1 + INR interest rate)

Forward rate = ₹83.40 − 83.50 × (1 + 0.0025) / (1 + 0.0640) = ₹86.302 − 86.407. Therefore, the one year forward rate for Euro is ₹86.30 − 86.41.

To determine if there is an arbitrage opportunity, we compare the calculated forward rate with the given forward rate of €1 = ₹86.50 − 87.25. Since the forward rate calculated is lower than the given forward rate, there is no arbitrage opportunity.