Question

1.

CIA

Assume the following interest rate and exchange rate quotes. You can borrow $1,000,000

or its yen equivalent ¥101,000,000:

Spot exchange rate:

¥101/$

1-year forward rate:

¥100/$

1-year $ interest rate:

1.50%

1-year ¥ interest rate:

0.70%

.

Use the rule of thumb to identify whether coved interest arbitrage is worthwhile. If yes,

what is your strategy and how much is your profit (show the steps)? What market forces

would occur to eliminate any further possibilities of covered interest arbitrage?

Answer 1

Solution:

Arbitrage opportunity:

Spot exchange rate:

¥101/$

1-year forward rate:

¥100/$

1-year $ interest rate:

1.50%

1-year ¥ interest rate:

0.70%

Step1: Borrow $1,000,000 in US and we will have to pay 1.5% interest so we need to reppay total amount = $1,000,000 *(1+1.5%) = 1,015,000

Step 2: Convert the USD into yen at prevailing exchnage rate i.e. ¥101/$

So $1,000,000 =  ¥ 101,000,000

Step 3: We will earn interest of 0.7% in Japan.

So this 101,000,000 will become 101,000,000 *(1+0.7%) = 101,707,000

Step 4: Convert this into $ at 1-year forward rate and repay the loan

Forward rate = ¥100/$

101,707,000 yen = $101,707,000/ 100 = $1,017,070  

Now repay the borrowed amount with interest

Profit = 1,017,070 - 1,015,000 = $2070

If the interest in the US increases then this opportunity can be eliminated ( from 1.5% to 1.707%)

or the exchange rate increase from ¥100/$ to ¥100.20394/$