Asked by marta kebede on Jul 09, 2024
Verified
Suppose that the risk-free rates in the United States and in the United Kingdom are 5% and 4%, respectively. The spot exchange rate between the dollar and the pound is $1.80/BP. What should the futures price of the pound for a one-year contract be to prevent arbitrage opportunities, ignoring transactions costs?
A) $1.62/BP
B) $1.72/BP
C) $1.82/BP
D) $1.92/BP
Risk-free Rates
Risk-free Rates represent the return on investment of an absolutely safe asset, with no risk of financial loss, typically exemplified by treasury bills of a stable government.
Spot Exchange Rate
The existing exchange value for immediate buying or selling of a currency.
Futures Price
The agreed-upon price for the future delivery of a particular commodity, financial instrument, or currency.
- Identify and determine the appropriate futures prices to forestall arbitrage activities based on differences in interest rates and the values of exchange rates.
Verified Answer
GL
Gabriella LucarelliJul 11, 2024
Final Answer :
C
Explanation :
The futures price of the pound can be calculated using the interest rate parity formula, which states that the future exchange rate is equal to the spot exchange rate multiplied by the ratio of the interest rates in the two countries. Therefore, the calculation is $1.80 * (1.05 / 1.04) = $1.82/BP. This prevents arbitrage opportunities by ensuring that the cost of borrowing in one currency, converting it to another, investing it, and then converting back at the future rate, will not yield a risk-free profit.
Learning Objectives
- Identify and determine the appropriate futures prices to forestall arbitrage activities based on differences in interest rates and the values of exchange rates.