Question

Assume the following information:

1-year deposit rate offered on U.S. dollars    =          2.5%

1-year deposit rate offered on Singapore dollars       =          4.0%

1-year forward rate of Singapore dollars       =          $0.78

Spot rate of Singapore dollar =          $0.80

Given this information, does covered interest arbitrage worthwhile for a US investor? Assume the investor invests $1,000,000

(______)

Please do not round during intermediate steps and round your final answer to two decimal places.

Answer 1

Particulars	Amount
Spot Rate	$             0.7800
Hi	2.5000%
Fi	4.0000%
Home Country	US
Foreign Country	Singapore
Forward rate after ( in Years)	1
Actual Fwd Rate	$             0.8000
Fwd rate after ( In Months)	12
Amount Borrowed	$ 1,000,000.00

According to Int Rate parity Theorm,  
Fwd rate After 1 Years = Spot rate * [ ( 1 + Hi ) ^ n ] / [ ( 1 + Fi ) ^ n ]  
= $ 0.78 * [ ( 1 + 0.025) ^ 1 ] / [ ( 1 + 0.04 ) ^ 1 ]   
= $ 0.78 * [ ( 1.025) ^ 1 ] / [ ( 1.04 ) ^ 1 ]   
= $ 0.78 * [ 1.025 ] / [ 1.04 ]   
= $ 0.78 * [ 0.9856 ]   
= $ 0.7688  
  
As Actual Fwd rate is not equal to IRPT Fwd rate, Covered Interest arbitrage exists.  
  
Foreign Currency Premium or Discount:  
= [ [ Fwd rate - Spot Rate ] / Spot Rate ] * 100   
= [ [ $ 0.8 - $ 0.78 ] / $ 0.78 ] * 100   
= [ [ $ 0.02 / $ 0.78 ] * 100   
= [ 0.0256 ] * 100   
= 2.5641 %  
  
Annualized % = Premium or Discounted / No. of Years  
= 2.5641 % / 1  
= 2.56 %   
  
Effective Rate in Home Country   = 2.50%
Effective Rate in Foreign Country =    6.56%
  
Effective Rate in Foreign currency = Int rate + Fwd Premium %  
= 4 % + 2.56 %   
= 6.56 %  
  
  
Country which is cheap to Borrow is Home Country i.e US  
  
If Home Country is Cheap:  
Arbitrage Strategy :  

Step	Activity
1	Borrow in Home Country
2	Convert Into Foreign currency using spot rate
3	Invest in foreign currency for specified period
4	Realize the Maturity Value in Foreign Currency
5	Convert foreign currency proceedings into Home Currency using Actual Fwd Rate
6	Maturity of Loan in Home country
7	Repay the loan along with Int and book profit

Step 1:  
Amount Borrowed   $1,000,000.00
Step 2:  
Amount in Foreign Currency   1,282,051.28
Step 3:  
Invest in foreign currency for specified period   1 Years
Step 4:  
Realize the Maturity Value in Foreign Currency  
Maturity Value = Amount Deposited * ( 1 +r ) ^ n   
r = Int Rate per anum  
n - Time period in Years  
= 1282051.28 * ( 1 + 0.04 ) ^ 1  
= 1282051.28 * ( 1.04 ) ^ 1  
= 1282051.28 * ( 1.04 )   
= 1333333.33  
  
Step 5:  
Convert foreign currency proceedings into Home Currency using Actual Fwd Rate  
= 1333333.33 * 0.8  
= $ 1066666.66   
  
Step 6:  
Maturity of Loan in Home country  
= $1000000 * ( 1 + 0.025 ) ^ 1  
= $ 1000000 * ( 1.025 ) ^ 1  
= $ 1000000 * ( 1.025 )  
= $ 1025000  
  
Step 7  
Profit = Amount realized from Inv - maturity Value of Loan  
= $ 1066666.66 - $ 1025000  
= $ 41666.66
  
Book Profit of $ 41666.66
Pls comment, if any further assistance is required.