Question

In: Finance

Suppose that you’re a FX trader for a bank in New York. You are faced with...

Suppose that you’re a FX trader for a bank in New York. You are faced with the following market rates:

Spot exchange rate: Sfr 0.9525/$. In other words, 1 US dollar = 0.9525 Swiss francs

6 month US dollar interest rate = 0.80% per annum

6 month Swiss franc interest rate = 0.15% per annum

6 month forward exchange rate: = Sfr 0.9445/$

The maximum amount you may borrow and/or invest is $10,000,000 or its equivalent in Swiss francs.

a) Is there a covered interest arbitrage opportunity? Explain why or why not.

b) Continuing with the problem, spell out the actions you would take to profit from this situation. Your response should include step-by-step verbal explanations as well as detailed calculations.

  • Which currency and how much of it would you borrow? Which currency and how much would you lend (invest)?
  • What is the forward transaction you would engage in? Specify which currency and what quantity of that currency you would sell forward and which currency and what quantity of it you would buy forward.
  • What is the amount of arbitrage profits? Clearly explain your calculations in words.

Solutions

Expert Solution

As per Interest Rate Parity,

Theoretical Forward Rate Sfr/$ = Spot Sfr/$*(1+Interest Rate on Swiss Franc)/(1+Interest Rate on $)

= 0.9525*[1+(0.0015/2)]/[1+(0.008/2)]

= 0.9494

Actual Forward Rate < Theoretical Forward Rate

As the Rates are different, there is a Covered Interest Arbitrage Opportunity.

Therefore, Actual Forward Rate of $ is Undervalued

To make an Arbitrage Gain, Sell $ in Spot and Buy in Forward

Steps to make an Arbitrage Gain:

Now,

  1. Borrow $10000000 for 6 months
  2. Buy Sfr at Spot Rate using $10000000 and receive 10000000*0.9525 = Sfr 9525000
  3. Invest Sfr 9525000 for 6 months
  4. Enter into Forward Contract to Sell 9525000*(1+0.00075) = Sfr 9532143.75

After 6 months,

  1. Realize Investments and receive 9525000*(1+0.00075) = Sfr 9532143.75
  2. Sell Sfr 9532143.75 under Forward Contract and receive 9532143.75/0.9445 = $10092264.43
  3. Repay the borrowings along with interest and pay 10000000*(1+0.004) = $10040000
  4. Arbitrage Gain = Difference = $10092264.43 - $10040000 = $52264.43

jeff jeffy answered 6 months ago
Next > < Previous

Related Solutions

A Foreign currency trader at the bank’s FX desk calls to inform you that Bank of...
A Foreign currency trader at the bank’s FX desk calls to inform you that Bank of America is quoting $1.12/€1, and Citibank is offering $1.28/£1. The trader also noticed that Credit Agricole is making market in pound sterling and Euro at €1.18/£1. a. What is the implied €/£ cross-rate for the two European currencies? Show this trader how you would use $1 million to conduct a triangular arbitrage to profit from the deviation (if any) of the implied cross rate...
A Foreign currency trader at the bank’s FX desk calls to inform you that Bank of...
A Foreign currency trader at the bank’s FX desk calls to inform you that Bank of America is quoting $1.12/€1, and Citibank is offering $1.28/£1. The trader also noticed that Credit Agricole is making market in pound sterling and Euro at €1.18/£1. a. What is the implied €/£ cross-rate for the two European currencies? Show this trader how you would use $1 million to conduct a triangular arbitrage to profit from the deviation (if any) of the implied cross rate...
Rose Lever is a foreign exchange trader for a bank in New York. She observes the...
Rose Lever is a foreign exchange trader for a bank in New York. She observes the following​ rates: Spot exchange​ rate: ​ SF0.9872/$ ​3-month forward​ rate: SF0.9907/$ ​3-month U.S. interest​ rate: 2% per annum ​3-month Swiss interest​ rate: 4% per annum a. Can you help Ms. Lever identify whether there is an arbitrage opportunity or not by calculating the theoretical forward​ rate? b. Can you help Ms. Lever form a covered interest arbitrage strategy to generate​ profit? Please describe each...
Kavita Raman is a foreign exchange trader for a bank in New York. She can borrow...
Kavita Raman is a foreign exchange trader for a bank in New York. She can borrow $1 million (or its Swiss franc equivalent) at her disposal for a short term money market investment. Kavita wonders whether she should make an uncovered interest arbitrage (UIA) transaction. She faces the following quotes: Assumptions Arbitrage funds available $1,000,000 Spot exchange rate (SFr/$) 1.2810 3-month forward rate (SFr/$) 1.2740 U.S. dollar 3-month interest rate 4.800% per year Swiss franc 3-month interest rate 3.200% per...
Casper​ Landsten-UIA (B).   Casper Landsten is a foreign exchange trader for a bank in New York....
Casper​ Landsten-UIA (B).   Casper Landsten is a foreign exchange trader for a bank in New York. Using the values and assumptions​ below, he decides to seek the full 4.804​% return available in U.S. dollars by not covering his forward dollar receiptslong dash—an uncovered interest arbitrage​ (UIA) transaction. Assess this decision. Arbitrage funds available $ 950,000 Spot exchange rate (SFr/$) 1.2811 3-month forward rate (SFr/$) 1.2742 Expected spot rate in 90 days (SFr/$) 1.2697 U.S. Dollar annual interest rate 4.804 %...
3.CIA Susan Prescott is a foreign exchange trader for a bank in New York. She has...
3.CIA Susan Prescott is a foreign exchange trader for a bank in New York. She has $1 million (or its Swiss franc equivalent) for a short term money market investment and wonders if she should invest in U.S. dollars for three months, or make a covered interest arbitrage (CIA) investment in the Swiss franc. She faces the following quotes: Assumptions Value SFr. Equivalent Arbitrage funds available $1,000,000 SFr. 994,000 Spot exchange rate (SFr./$)                    .9940 3-month forward rate (SFr./$)                    .9910 U.S....
Casper​ Landsten-UIA (B). Casper Landsten is a foreign exchange trader for a bank in New York....
Casper​ Landsten-UIA (B). Casper Landsten is a foreign exchange trader for a bank in New York. Using the values and assumptions​ below, he decides to seek the full 4.798 return available in U.S. dollars by not covering his forward dollar receipts —an uncovered interest arbitrage​ (UIA) transaction. Assess this decision. Arbitrage funds available $ 1,100,000 Spot exchange rate (SFr/$) 1.2809 3-month forward rate (SFr/$) 1.2744 Expected spot rate in 90 days (SFr/$) 1.2704 U.S. Dollar annual interest rate 4.798 %...
With the expertise that you have gained, you are contemplating becoming a FX trader. You want...
With the expertise that you have gained, you are contemplating becoming a FX trader. You want to speculate on a particular currency (Japanese JPY Yen). What is a better choice for speculating futures contracts or options contracts? Refer to these websites: Www.cme.com Www.PHLX.com
You are contemplating becoming a fx trader. You want to speculate on a particular currency (Canadian...
You are contemplating becoming a fx trader. You want to speculate on a particular currency (Canadian Dollar). What is a better choice for speculating futures contracts or options contracts?
The officers of an oil refiner, trader, and hedger based in New York were arrested by...
The officers of an oil refiner, trader, and hedger based in New York were arrested by the FBI for committing massive financial statement fraud. The executives used many schemes to perpetuate the fraud, one of which was to hide a $30 million accounts payable from the auditors and show it as a payable arising in the following year. To conceal the fraud, they altered purchasing records, using correction fluid, and provided only photocopies of the records to the auditors. The...
ADVERTISEMENT
Subjects
ADVERTISEMENT
Latest Questions
ADVERTISEMENT