Suppose that the one-year interest rate is 5.0 percent in the united states and 3.5 percent in germany, and that the spot exchange rate is $1.12/€ and the one-year forward exchange rate, is $1.16/€. assume that an arbitrageur can borrow up to $1,000,000. if an astute trader finds an arbitrage, what is the net cash flow in one year? a. $10,690 b. $15,000 c. $46,207 d. $21,964.29

Spot x (1+domestic interest rate)/(1+foreign interest rate)=Forward rate

1.12*(1+0.05)/(1+0.035)=1.136

The forward rate should be $1.136/€  but is $1.16/€  so we have an arbitrage opportunity.

Because we believe that $ is being undervalued and €  is over valued (one euro should be have a forward rate of $1.136/€  but has a rate of $1.16/€ )

We will borrow 1,000,000 at a 5% interest rate which means that at the end of the year we will have to pay = $1,050,000, this will be our negative cash flow.

We will then buy 1,000,000/1.12=€ 892,857 and Earn an interest of 3.5% on the Euros. At the end of the year we will get payed 924,107. This will be our positive cash flow. At the start of the year we will get into a forward contract in which we will sell the €924,107 for $1,071,964(924,107*1,16).Because the forward rate is $1,16/€ we will get 1.16 dollars for every euro.

At the end of the year we will have $1,071,964 from our forward contract and will have to pay   1,050,000 as our loan payment so we will be left with (1,071,964-1,050,000)= $21,964

D. $21,964.29 will be our net cash flow from this Arbitrage opportunity.

Explanation:

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