Question:

a) Using illustrative and numerical examples, differentiate between speculation and arbitraging in the context of foreign exchange market.

b) One year borrowing and deposit interest rates are 12% and 10% respectively in the US and 10% and 8.89% respectively in Switzerland. The spot exchange rate for the US dollar is $14 to the Swiss Franc. The 12-month forward rate is $14.52. The economies are pegged together, and have been so for a number of years.

i) Suggest a way you might profit from the pricing inconsistency that is presented here, assuming you have no initial investment funds.

ii) Will the situation persist forever? Explain your answer.

iii) What could be the spot rate which would bring a no-arbitrage situation?