Implied Forward Exchange Rate
Suppose you are a wine maker in Santa Ynez, California (U.S.). You have ordered oak barrels from France for your vineyard. The barrels will arrive in one year, just in time for the Chardonnay from the upcoming 2010 harvest to be transferred from fermentation vats and aged. The barrels cost 122 EUR each, cash on delivery. There is no forward EUR/USD exchange rate beyond six months, but the 1-year EUR deposit rate is 4.75% while the Eurodollar deposit rate is 4.25%. Describe the transaction to lock in a dollar price per barrel and calculate that price (i.e., implied forward exchange rate for EUR/USD). The spot exchange rate is 1.2834 USD/EUR. Hint: Apply the intuition behind the Covered Interest Parity arbitrage proof.