Question

Suppose today's exchange rate is $1.480/€. The three-month interest rates on dollars and euros are 4 percent p.a. and 3 percent p.a., respectively. The three-month forward rate is $1.475. A foreign exchange advisory service has predicted that the euro will appreciate to $1.495 within three months.

Which strategy using forward contracts would give you the highest profit in the above situation and what will be the annualized return from the strategy?

Select one:

a. Buy euros forward and sell them in the spot market in three months; 1.36%

b. Sell euros today and buy them in the spot market in three months; 1.01%

c. Sell euros forward and buy them in the spot market in three months; 5.35%

d. Buy euros forward and sell them in the spot market in three months; 4.05%

e. Buy euros forward and sell them in the spot market in three months; 5.42%

Answer 1

Which strategy using forward contracts would give you the highest profit in the above situation and what will be the annualized return from the strategy?

(D) Buy euros forward and sell them in the spot market in three months; 4.05%

As the difference in euro return will be adjusted with diffrence in currency rate. The spot rate will also be adjusted with three months rate.

This principle advocates for borrowing currency in which the rate of interest is lower and investing into such currency which will return higher in future and shorting it in spot to hedge the position. the profit will be repaid to adjust with interest on borrowing.