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

IMPORTANT CONCEPT: In equilibrium in the country whose currency is expected to depreciate relative to another country’s currency, the interest rate should be higher than in the other country to compensate for that depreciation.

IMPORTANT CONCEPT: In equilibrium in the country whose currency is expected to depreciate relative to another country’s currency, the interest rate should be higher than in the other country to compensate for that depreciation.