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CA Final · Advanced Financial Management · International Financial Management

Spot EUR/INR is 90.00 and the one-year forward quoted by a bank is 92.70. One-year interest rates are 6% in India and 3% in the Eurozone. A treasurer at an Indian firm with no transaction costs examines arbitrage. Which statement is correct?

The parity forward is 90 × 1.06/1.03 = 92.62. The bank's 92.70 exceeds it, so an arbitrage profit exists by borrowing rupees, buying euros spot, investing them and selling euros forward at the higher rate.

  1. ANo arbitrage exists because the forward premium equals the interest differential exactlyCorrect
  2. BArbitrage exists: borrow in INR, buy EUR spot, invest in EUR and sell EUR forward, but the profit is zero
  3. CThe forward is too low relative to parity, so borrow EUR and invest in INR
  4. DArbitrage exists: the parity forward is 92.70 divided by 1.03, so the bank forward is too high

Explanation

Parity forward = 90 × 1.06/1.03 = 92.62, not 92.70. Recomputing: 90 × 1.029126 = 92.62. So the quoted 92.70 is higher than parity, and the forward is too high; arbitrage exists by borrowing INR, buying EUR, investing and selling EUR forward at 92.70.

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