Assume that the 1-year interest rate in the US is 2% and the 1-year interest rat
ID: 2716426 • Letter: A
Question
Assume that the 1-year interest rate in the US is 2% and the 1-year interest rate in Sweden is 4%. You have no additional information on the spot or the forward rate.
a) Assume you observe in the market that the Swedish Kronor (SKR) trades at a forward premium to the US Dollar (USD). Is this evidence of an arbitrage opportunity? If yes, explain in detail how you would structure the sequence of trades to benefit from it and why you can be sure to generate a profit in that way (assuming you are free to borrow and invest at the stated interest rates, there is no bid-ask spread). If no, explain why not.
Explanation / Answer
Arbitrage is a trading in which one has to buy goods or services from one market and sale it immediately into another market and get riskless return.
In this present case, interest rate in Sweeden is 2% higher than US rate. So, arbitrage opportunity exists. forward rate for this is X = (1.04/1.02) x Y. Or, X (Doller)= 1.0196Y (SKR).
In this situation, A Company haveng overseas branch in Sweeden can get loan from US at 2% interest and immediately send it to Sweeden and get 2% benefit