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       =          $0.795

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 four decimal places.

please show work

Answer 1

As per IRP theory any covered interest rate arbitrage between two countries will be nullified by change in the exchange rate . This also helps us to calculate the forward exchange rates

The formula to calculate the forward exchange rate is

F = S * (1+ia)/(1+ib)

Where F is the forward exchange rate

S is the spot exchange rate

ia is the interest rate in country A

ib is the interest rate in country B

Hence Given that S = 0.8

And Now , F = 0.8 * ( 1+ 0.04)/(1 + 0.025)

Hence F = 0.811707

However the actual forward rate is $0.795

Hence there is a covered interest rate arbitrage possible.

Let us check if he can make profits or not

To make covered interest rate arbitrage an investor has to first borrow USD and Invest the same in Singapore

because interest rates in US are lower than that in Singapore hence.

We have been given to invest $1,000,000

If we deposit this 1,000,000 in US we get

1,000,000 + 1,000,000 * 2.5% at the end of year -3

= 1025000.

If we invest this amount in Singapore then we will get

1,000,000/0.8

= 1250000

After 1 year we get 1250000 + 1250000 * 0.04 = 1300000

Now we will convert this into USD and we will get 1300000 * 0.795 = 1033500

Hence if we invest the amount of  1,000,000 USD we will get (1033500 - 1025000) = 8500 Excess dollars as return