A currency dealer has good credit and can borrow either $1,000,000 or €800,000 for one year. The one-year interest rate in the U. S. is i$ = 2% and in the euro zone the one-year interest rate is i€ = 6%. The one-year forward exchange rate is $1.20 = €1.00; what must the spot rate be to eliminate arbitrage opportunities?

The spot exchange rate must be $1.25 = €1.00

Explanation:

Note that if the currency dealer borrows €800,000 with an interest in € = 6%; using the spot exchange rate of $1.25=€1 to invest in the U. S. dollars at interest in $ = 2% for one year, he makes reasonable profit if after one he exchanges $848,000 into euro at the forward rate of $1.20 = €1.00.

His Net profit becomes $2,400.