Question

Suppose that the risk-free rates in the United States and in Japan are 5.25% and 4.5%, respectively. The spot exchange rate between the dollar and the yen is $0.008828/yen. What should the futures price of the yen for a one-year contract be to prevent arbitrage opportunities, ignoring transactions costs

Answer 1

$0.008891/Yen

Explanation:

The computation of arbitrage free rate is shown below:-

Fair forward rate = Spot rate × (1 + Interest rate US) ÷ (1 + Interest Rate Japan)

= 0.008828 × (1 + 5.25%) ÷ (1 + 4.5%)

= $0.00889135885/Yen

or

= $0.008891/Yen

Therefore for computing the arbitrage free rate we simply applied the above formula.