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FRM Part I · FRM Exam Part I · Pricing Conventions, Discounting, and Arbitrage

The EUR/USD spot rate is 1.2000 USD per EUR. The continuously compounded risk-free rates are 3% in USD and 1% in EUR. What is the no-arbitrage two-year forward rate in USD per EUR?

The two-year forward rate is 1.2490 USD per EUR. Under covered interest parity, spot is compounded at the difference between the domestic (USD) and foreign (EUR) rates, 2%, for two years. The higher-rate USD therefore trades at a forward discount.

  1. A1.2490Correct
  2. B1.1529
  3. C1.2000
  4. D1.2742

Explanation

By covered interest parity, F = S0 × e^((r_USD − r_EUR)T) = 1.2000 × e^(0.02×2) = 1.2000 × 1.040811 = 1.2490. Reversing the rate differential gives 1.1529. Using only the USD rate gives 1.2742.

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