Question

4.UIA .Susan Prescott, using the same values and assumptions as in the previous question, now decides to seek the full 2.600% return available in US dollars by not covering her forward dollar receipts -- an uncovered interest arbitrage (UIA) transaction. Assess this decision.
Assumptions		Value				SFr. Equivalent
Arbitrage funds available		$1,000,000				SFr.994,000
Spot exchange rate (SFr./$)		.9940
3-month forward rate (SFr./$)		.9910
Expected spot rate in 90 days (SFr./$)		.9940
U.S. dollar 3-month interest rate		2.600% pa
Swiss franc3-month interest rate		1.600% pa

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 / $

If Susan does not cover the forward $ receipts, then the future $ receipts will be converted at the expected spot rate after 90-days instead of the forward rate.

Consequently, uncovered 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 expected rate of SFr 0.994 / $ to yield (1006500 x 0.994) = SFr 1000461

- Arbitrage Profit = Investment Proceeds - Repayment Liability = 1000461 - 997230.5 = SFr 3230.5