Question

Suppose you receive the following quotes (TND = Tunisian Dinar, EUR = Euro):

	Bank’s Bid	Bank’s Ask
Spot #TND to 1 Euro	TND 3.0345/euro	TND 3.0385/euro
90-day forward TND to 1 Euro	TND 3.1170/euro	TND 3.1212/euro

	Euro Area	Tunisia
90-day deposit rates (annual basis)	0.25%	10.8%
90-day borrowing rates (annual basis)	0.35%	11.0%

Assume an investor must borrow funds in order to engage in arbitrage activities. Given these quotes, is covered interest arbitrage profitable? Show the work and explain briefly. If a profit can be obtained, how would each of the quotes adjust?

Answer 1

I. Evaluation of borrow in TND say 10,000TND

1	Borrow at 11% pa		TND 10,000
2	Convert to euro at spot ask	10000/3.0385	Euro 3291.10
3	Invest at .25% pa		Euro 3291.10
4	Take forward Cover
5	Realise matured investment	3291.10+(3291.10*.25%*90/365)	Euro 3293.13
6	Reconvert to TND at forward bid	3293.13*3.1170	TND 10,264.69
7	Repay borrowings in step 1	10000+(10000*11%*90/365)	TND 10,271.23
8	Arbitrage gain/(Losss) step6-step7		(6.54)

Therefore investor has arbitrage loss on borrowing from Tunisia.

I. Evaluation of borrow in Euro say 1,000 Euro

1	Borrow at .35% pa		Euro 1,000
2	Convert to TND at spot bid	1000*3.0345	TND 3034.50
3	Invest at 10.8% pa		TND 3034.50
4	Take forward Cover
5	Realise matured investment	3034.50+(3034.50*10.8%*90/365)	TND 3115.31
6	Reconvert to Euro at forward ask	3115.31/3.1212	Euro 998.11
7	Repay borrowings in step 1	1000+(1000*.35%*90/365)	Euro 1000.86
8	Arbitrage gain/(Losss) step6-step7		(2.75)

In this case also the investor have no arbitrage gain.