Kenneth R. Szulczyk
Forward contract issued today at time t for currency delivery on a future specific date on T
is F.International investors use arbitrage to price a forward contract. An investor invests $1
within the United States for T days and earns the domestic interest rate. We compute his or her
rate of return in U.S. dollar in Equation 25.
360
T
rd 1 1 +id (25)Investor believes Malaysia offers better investment opportunities and invests in Malaysia
for T days, earning the foreign interest rate. Consequently, the investor exchanges the U.S.
dollars for Malaysian ringgits at the spot exchange rate. Exchange rate equals U.S. dollars per
Malaysian ringgit, denoted by S. Rate of return of the Malaysian investment yields Equation 26
because the interest and principal are denominated in ringgits.
S
T
+if1
360
(^1)
(26)
At time t, the investor buys a T-day forward contract to exchange the ringgits back into U.S.
dollars, once the investment has ended. Investor exchanges the ringgits for U.S. dollars at the
U.S. dollar-ringgit exchange rate, F. Thus, the investor locks into a forward contract today for a
fixed exchange rate protecting the investor from the exchange rate risk. We calculated the rate
of return in U.S. dollars of the Malaysian investment in Equation 27.
S
F
360
T
rf 1 +if
1 (27)
Investor is indifferent between investing in the United States and Malaysia. Consequently,
the investors use arbitrage to invest in United States and Malaysia until the rates of return for
both countries converge to the same rate. Thus, we can set the two investments equal to each
other, yielding Equation 28.
rf 1 rd 1 (28)
360
1
360
1
T
= +iT
+i
SF
f d^Solving for the forward contract yields Equation 29: