Assume that the 1-year interest rate in the US is 2% and the 1-year interest rate in Sweden is 4%. You have no additional information on the spot or the forward rate. a. Assume you observe in the market that the Swedish Kronor (SKR) trades at a forward premium to the US Dollar (USD). Is this evidence of an arbitrage opportunity? If yes, explain in detail how you would structure the sequence of trades to benefit from it and why you can be sure to generate a profit in that way (assuming you are free to borrow and invest at the stated interest rates, there is no bid-ask spread). If no, explain why not
b) The trading strategy you described in question a. will lead to adjustments in the market. Describe how every of the following parameters is likely to change as a result of arbitrage activity. Specifically:
- What is likely to happen to the USD / SKR spot rate and why?
- What is likely to happen to the USD / SKR forward rate and why?
- What is likely to happen to Swedish interest rate and why?
- What is likely to happen to the US interest rate and why?