Suppose that the risk-free rates in the United States and in the United Kingdom are...
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Suppose that the risk-free rates in the United States and in the United Kingdom are 4% and 3%, respectively. The spot exchange rate between the dollar and the pound is $1.40/BP. What should the futures price of the pound for a one-year contract be to prevent arbitrage opportunities, ignoring transactions costs? Assume the following information: rUS = 4%; rUK = 3% E0 = 1.266 F0=1.388 (1-year delivery)
a) Are the above rates stated as a direct exchange rate quote, or an indirect exchange rate quote? Explain.
b) What is the size for this futures contract?
c) Is there an arbitrage opportunity here? Why or why not?
d) Construct an arbitrage model to exploit the above pricing relationship. Show your actions and cash flows in numbers and algebraically. e) Assume that F0 is actually not 1.388 but rather 1.166, construct an arbitrage model to exploit this pricing relationship.
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