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FRM Part I · FRM Exam Part I · Foreign Exchange Markets

A trader observes a spot GBP/USD rate of 1.2500 USD per GBP, a one-year GBP rate of 4.00% and a one-year USD rate of 6.00%. The one-year forward GBP/USD quote is 1.2800. Ignoring transaction costs, which strategy captures an arbitrage profit?

The parity forward is about 1.2740, below the quoted 1.2800. Selling GBP forward at the inflated rate is profitable, so the trader borrows USD, buys GBP spot, invests in GBP at 4%, and sells the GBP proceeds forward at 1.2800.

  1. ABorrow USD, convert to GBP at spot, invest in GBP, sell GBP forwardCorrect
  2. BBorrow GBP, convert to USD at spot, invest in USD, buy GBP forward
  3. CBorrow USD, convert to GBP at spot, invest in GBP, buy GBP forward
  4. DBorrow GBP, convert to USD at spot, invest in USD, sell GBP forward

Explanation

Parity forward = 1.2500 × 1.06/1.04 = 1.2740. The quoted 1.2800 is higher, so GBP is overvalued forward: sell GBP forward at 1.2800. Hence borrow USD, buy GBP spot, invest at 4%, and lock in the sale of proceeds at 1.2800. Options buying GBP forward would lock in the wrong direction.

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