Los 19.b

Question 1

What is the no-arbitrage condition in forward currency contracts?

Answer 1

The no-arbitrage condition states that the percentage difference between forward and spot exchange rates should be approximately equal to the interest rate differential between two countries, to prevent riskless profit from arbitrage.

Question 2

How does arbitrage work when the no-arbitrage condition is violated?

Answer 2

If the forward rate does not reflect the interest rate differential, you can borrow in one currency, convert it to a foreign currency, invest it at the foreign interest rate, and then sell it forward to earn a riskless profit.

Question 3

What is the formula for the no-arbitrage condition?

Answer 3

(1+r domestic) = (1 / Spot rate) * (1 / forward rate(1 + rforeign)

Question 4

How is the forward exchange rate quoted in points?

Answer 4

The forward exchange rate is quoted as a difference from the spot exchange rate in points (last decimal place).
Example: If the spot rate is 0.7313 and the forward rate is quoted at +3.5 points, the forward rate is 0.73165.

Question 5

What is the forward premium or discount?

Answer 5

The forward premium or discount is the percentage difference between the forward and spot exchange rates.
Example: Forward rate / spot rate -1 = 1.32 / 1.312 -1 = 0.610% (forward prem)

Question 6

: What does a positive forward premium indicate?

Answer 6

A positive forward premium indicates that the base currency is expected to appreciate relative to the quote currency, and the quote currency will depreciate.