Question 1 Suppose a forex trader makes the following statement, “liquid currencies would be more volatile...

Question 1 Suppose a forex trader makes the following statement, “liquid currencies would be more volatile than the illiquid ones.” Explain why would you agree or disagree with the trader’s statement.

Question 2 A forex trader has $1,000,000 (or its Swiss franc equivalent) to use in a forex speculation. The spot exchange rate is USD1.0524/CHF and the relevant 3-month interest rates (un-annualized) in the US and Switzerland are 3.8% and 5.3%, respectively. Suppose the trader can make a precise forecast and the future spot rate in 90 days will be USD1.0627/CHF, explain how the trader can perform arbitrage. How much arbitrage profit can the trader obtain? Explain your working

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Expert Solution

Question 1

You would agree with trader's statement because there will be more transactions in liquid currencies which would affect demand and supply of liquid currencies and in turn make them more volatile. due to this volatility prices of liquid currencies will change very frequently.

There will be very less or almost no transaction in illiquid currencies. so there prices will change rarely and be less volatile.

Question 2

A forex trader has $1,000,000. 3-month interest rate in US is 3.8% and in Switzerland 5.3%. To perform the arbitrage, trader can invest equivalent CHF of $1,000,000 converted using spot rate in Switzerland and earn 5.3% interest for 3-months. after 3-months he can covert that CHF principal+interest in to dollars using future spot rate in 90 days.

CHF value to be invested = $1,000,000/USD1.0524/CHF = CHF 950,209.05

Interest earned on CHF investment = CHF 950,209.05*5.3% = CHF 50,361.08

Investment value after 3-months = Principal+interest = CHF 950,209.05 + CHF 50,361.08 = CHF 1,000,570.13

USD value of Investment value after 3-months = CHF 1,000,570.13*USD1.0627/CHF = $1,063,305.88

arbitrage profit = Investment value after 3-months - initial investment = $1,063,305.88 - $1,000,000 = $63,305.88

jeff jeffy answered 2 days ago

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