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

Question

Quizplus · Accepted Answer

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.

Suppose That the Risk-Free Rates in the United States and in the United