Question

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. dollar 3-month interest rate		2.600% pa
	Swiss franc3-month interest rate		1.600% pa

What should Susan do?

Answer 1

Arbitrage fund available = $ 1000000 or SFr 994000, USD Interest Rate = 2.6 % per annum, Swiss France Interest Rate = 1.3%,

Spot Rate = SFr 0.994 / $ and Forward Rate = SFr 0.991 / $

In order to execute a covered interest arbitrage, Susan should borrow the currency with lower interest rate and invest in the currency with higher interest rate.

Consequently, covered interest arbitrage can be executed as described below:

- Borrow SFr 994000. Convert this borrowing into $ at spot rate to yield (994000 / 0.994) = $ 1000000

- Borrowing creates a repayment liability worth 994000 x [1+(0.013/4)] = $ 997230.5

- Invest converted $ 1000000 at the USD Interest Rate for 3-months to yield 1000000 x [1+(0.026/4)] = $ 1006500

- Convert investment proceeds at the 3-month forward rate of SFr 0.991 / $ to yield (1006500 x 0.991) = SFr 997441.5

- Arbitrage Profit = Investment Proceeds - Repayment Liability = 997441.5 - 997230.5 = SFr 211