Question

Assume you have a foreign currency contract expiring in 3 months. The current price of the future contract is 0.82.

Assuming that you have the current exchange rate between domestic currency and foreign currency is 0.83 and the domestic risk free rate is 0.05 and the foreign risk free rate is 0.1 who has the arb opporunity?
A) Nobody the contract is priced fairly
B) Buyer
C) seller
D) none of the above

Answer 1

The arbitrage opportunity is available to the seller of the foreign currency contract in this scenario.

The arbitrage opportunity is available to the seller of the foreign currency contract. Here's why:

1. Assuming that the current exchange rate is 0.83, the contract price of 0.82 is lower than the spot rate, creating a discount.
2. The domestic risk-free rate of 0.05 is lower than the foreign risk-free rate of 0.1. This means that investors can earn a higher return by investing in the foreign currency.
3. Considering these two factors, the seller can sell the foreign currency contract at 0.82, invest the proceeds at the higher foreign risk-free rate of 0.1, and then purchase the foreign currency at the spot rate of 0.83. This results in a profit for the seller.

Therefore, option C) seller has the arbitrage opportunity in this scenario.