Answer:
- International currency arbitrage is about simultaneous buy and sales of currency in the market to make risk-free profit from the differential in exchange rate and difference between market interest rate each currency brings about.
- In the question, from the French point of view, there are not opportunities for arbitrage.
To illustrate, for example, we have €10,000,000 for investment:
First, exchange €10,000,000 for £8,333,333.33 at spot ( 10 million /1.2)
Enter into Forward contract to fixed exchange rate after 90 days at £1.00 = €1.1765
Invest £8,333,333.33 at 90-day, 7% per annum to receive £8,479,166.66 at maturity ( Principal + interest = 8,333,333.33 x [1 + (7.0% x 90/360)] )
Convert £8,479,166.66 to €9,921,816.66 ( 8,433,333.33 x 1.1765).
While if we keep the amount in € and invest, we will get €10,120,000
=> Return on € of the investment is €9,921,816.66/€10,120,000 -1 = 1.96%
In other words, the higher return on £ denominated asset over the € is not large enough to cover the depreciation of £ in comparison to €.
- As investment in € denominated asset yields higher returns, investor will exchange have higher demand of £ in forward transaction which will increase the value of £ in forward transaction. Besides, higher demand for € denominated asset will cause the price to increase, that is, interest rate decrease. Gradually, the arbitrage transactions will exploit the arbitrage opportunity.
Explanation:
