"Assume that the rates shown in the table below accurately reflect current condi- tions in the financial markets.
Dollar/Euro Spot Rate 1.21 Dollar/Euro 1-Year Forward Rate 1.18 1-Year Deposit Rate: Euro 3% U.S. 2%
In the table, the one-year forward dollar/euro exchange rate is mispriced, because it doesn’t reflect the interest rate differentials between the U.S. and Europe.
A Calculate the amount of the current forward exchange discount or premium. B Calculate the value that the forward rate would need to be in order to keep riskless arbitrage from occurring."
From the problem given, I have a hard time identifying domestic currency. I calculated part A but for B, What do I put in the eqaution as 1+d ( domestic) is my q. In these type of q, from the quote, how do I identify the domestic currency?
1- (forward - spot )/ spot 2- but forward should be : Dollar/ euro spot x (1+int usd ) / (1+int euro) = forward 1.1983 … but the forward rate given is 1.18 so here they are overstating the dollar and understating the euro .
You cannot determine the domestic currency from the given quote. For a US investor, the USD is domestic, and for a French investor the EUR is domestic.
Is there a reason that you need to know which is domestic and which is foreign?
1- (forward - spot )/ spot 2- but forward should be : Dollar/ euro spot x (1+int usd ) / (1+int euro) = forward 1.1983 … but the forward rate given is 1.18 so here they are overstating the dollar and understating the euro .
Exactly. I was not sure what to put in for (1+int usd ) / (1+int euro). Whether USD rate goes in the nominator or Euro. See my confusion now?