Suppose we observe the following 1-year interest rates:
Euro $ = 15%
Euro SF = 12%
The exchange rate is quoted as the dollar price of Swiss francs and is currently E = 0.40.
(a) Given the information above, what is the 12-month forward rate?
(b) Suppose the actual 12-month forward rate is not what you found from (a), but instead is $0.42. What would profit-seeking arbitrageurs do?
(a) .15 - .12 = (F - .40)/.40, F = 0.412.
(b) Since the return to holding franc assets is higher, arbitrageurs buy franc assets and sell dollar assets.
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