Hello,
I’m hoping someone can help me with this problem I’m working on. Question below.
We would like you to consider the arbitrage possibilities in the foreign exchange market. Imagine you have the following information: the spot EUR/USD exchange rate is 0.82, the 2-year risk free rates (continuously compounded) are: 2.25% in USA and 0.35% in Euro zone.
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Find a two-year EUR/USD forward exchange rate that stems from a no arbitrage condition.
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Consider the following two situations:
Situation 1: suppose that the two-year forward exchange rate actually equals to 0.90EUR/USD
Situation 2: suppose that the two-year forward exchange rate actually equals to 0.70EUR/USD
For situation 1 provide a detailed arbitrage strategy (step by step) along with the related cash flows, while for situation 2, provide a brief summary of the arbitrage strategies. We would like you to do it from the perspective of both Eurozone and US investors.
Note, that a typical Euro futures contract offered by CME Group for US investors is for 125,000EUR. On the other hand, for Eurozone investors, the Eurexchange offers USD futures contracts of size of 100,000USD.
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Discuss and compare the arbitrage opportunities for US and Eurozone investors in terms of arbitrage profits. Would you prefer to be a US or Eurozone investor?
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Discuss the possibility of exploiting the arbitrage strategies for each situation and for each investor in reality. What, in your opinion, are the obstacles in financial markets that would make it difficult for the market participants to earn the arbitrage profit.
Thanks in advance!