C. Interest Arbitrage

U.S.

i=8%

France

i=8%

Exchange Rate

5 francs/$

One year

from now:

360-day Forward

exchange rate

4.8 francs/$

Now:

borrow $100,000

500,000 francs

540,000 francs

=500,000(1.08)

$112,500

$108,000

profit = $4,500

US credit market

French credit market

4.8

forward market

spot market

The forward exchange rate can be looked at as what the market expects the exchange rate to do in the future. As a result, the fact that the forward exchange rate is less than the spot rate indicates that the market expects that the exchange rate (francs/$) will go down. Since the exchange rate is the price of $s, this means the market expects the $ to depreciate.