Question

In: Finance

David Jensen is a foreign exchange trader with Citibank who has access to $2,000,000 US or...

David Jensen is a foreign exchange trader with Citibank who has access to $2,000,000 US or the UK pound (GBP) equivalent. He notices the following US dollar (USD) and UK pound (GBP) foreign exchange and interest rate quotes:

Spot exchange rate USD 1.2490 /GBP
Six months forward exchange rate USD 1.2535 /GBP
Expected spot exchange rate in six months USD 1.2610 /GBP
Six months $ interest rate 2.2% per year
Six months GBP interest rate 1.4% per year

Required:

  1. In the context of interest rate parity, under what conditions would an interest rate arbitrage be possible?
  2. Show the steps David would need to take to realise an uncovered interest rate arbitrage profit and calculate the profit?
  3. Discuss how a covered interest arbitrage strategy is different to an uncovered interest arbitrage strategy?

Solutions

Expert Solution

Current spot exchange rate: USD1.2490/GBP

Six month $ interest=(2.2/2)=1.1%=0.011

Six month GBP interest=(1.4/2)=0.7%=0.007

Future Value of USD 1.2490=1.2490*(1+0.011)=$1.262739

Future Value of 1GBP=1*(1+0.007)=1.007 GBP

As per interest rate parity,

Forward rate:

$1.262739/1.007GBP

$(1.262739/1.007)/GBP

$1.2540/GBP

Arbitrage will be possible if the forward exchange rate is different from $1.2540/GBP

Uncovered interest rate arbitrage:

Borrow in USA and invest in GBP

Borrow 2 million in USA at 2.2% interest

Convert the USD to ($2million/1.2490)= 1.601281 million GBP,at current spot rate

Invest 1.601281millionGBP at 1.4% interest

Future Value at end of 6 months=1.601281million*(1+0.007)=1.61249 million GBP

Expected exchange rate after 6 months:USD1.2610/GBP

Conversion of GBP after 6 months will amount to (1.61249*1.2610)million USD=2.0335Million USD

Amount to be paid back with interest =2*(1+0.011) million USD=2.022 million USD

PROFIT=(2.0335-2.022)Million USD=0.01135 million USD=$11,349.88

covered interest arbitrage strategy :

Under this strategy , The future rate risk is covered by entering into a forward contract .


Related Solutions

James Clark is a foreign exchange trader with Citibank. He notices the following quotes. __________________________________________________________________________________________________ Spot...
James Clark is a foreign exchange trader with Citibank. He notices the following quotes. __________________________________________________________________________________________________ Spot exchange rate USD1.2051/SFr Six-month forward exchange rate USD1.1922/SFr Six-month $ interest rate 8% per year Six-month SFr interest rate 10% per year ___________________________________________________________________________________________________ Is there an arbitrage opportunity? If yes, determine the arbitrage profit in Swiss Francs. Assume that James Clark is authorized to work with $1,000,000. Input your answer without any currency information.
A foreign exchange trader based in the US, authorized to borrow $450,000 or its foreign currency...
A foreign exchange trader based in the US, authorized to borrow $450,000 or its foreign currency equivalent faces the following quotes: Spot rate: $1.3000/pound Six Month Forward: $1.3085/pound US Interest Rate: 3.0% per annum UK Interest Rate: 2.0% per annum Is covered Interest arbitrage possible, and if so, how much profit can the trader make via 1 covered interest arbitrage transaction? Please show all steps and work.
Copenhagen Covered​ (A). Heidi​ Høi Jensen, a foreign exchange trader at J.P. Morgan​ Chase, can invest...
Copenhagen Covered​ (A). Heidi​ Høi Jensen, a foreign exchange trader at J.P. Morgan​ Chase, can invest ​$4.9 ​million, or the foreign currency equivalent of the​ bank's short term​ funds, in a covered interest arbitrage with Denmark. Using the following​ quotes, can Heidi make a covered interest arbitrage​ (CIA) profit? Arbitrage funds available $ 4,900,000 Spot exchange rate (kr/$) 6.1719 3-month forward rate (kr/$) 6.1984 U.S. dollar annual interest rate 2.950 % Danish krone annual interest rate 5.100 % The CIA...
eidi? Høi Jensen, a foreign exchange trader at J.P. Morgan ?Chase, can invest ?$5 ?million, or...
eidi? Høi Jensen, a foreign exchange trader at J.P. Morgan ?Chase, can invest ?$5 ?million, or the foreign currency equivalent of the? bank's short term? funds, in a covered interest arbitrage with Denmark. Using the following? quotes, can Heidi make a covered interest arbitrage? (CIA) profit? Arbitrage funds available $ 5,000,000 Spot exchange rate (kr/$) 6.1719 3-month forward rate (kr/$) 6.1977 U.S. dollar annual interest rate 3.000 % Danish krone annual interest rate 4.900 % The CIA profit potential is...
Heidi​ Høi Jensen, a foreign exchange trader at J.P. Morgan​ Chase, can invest ​$5 million, or...
Heidi​ Høi Jensen, a foreign exchange trader at J.P. Morgan​ Chase, can invest ​$5 million, or the foreign currency equivalent of the​ bank's short term​ funds, in a covered interest arbitrage with Denmark. Using the following​ quotes, can Heidi make a covered interest arbitrage​ (CIA) profit? If yes, then find the arbitrage profit in dollars. Clearly indicate the steps needed to take to realize the arbitrage profit. (Please note that the interest rates are quoted in annual terms, and that...
Heidi​ Høi Jensen, a foreign exchange trader at J.P. Morgan​ Chase, can invest ​$5 million, or...
Heidi​ Høi Jensen, a foreign exchange trader at J.P. Morgan​ Chase, can invest ​$5 million, or the foreign currency equivalent of the​ bank's short term​ funds, in a covered interest arbitrage with Denmark. Using the following​ quotes, can Heidi make a covered interest arbitrage​ (CIA) profit? If yes, then find the arbitrage profit in dollars. Clearly indicate the steps needed to take to realize the arbitrage profit. (Please note that the interest rates are quoted in annual terms, and that...
Copenhagen Covered​ (B). Heidi​ Høi Jensen, a foreign exchange trader at J.P. Morgan​ Chase, can invest...
Copenhagen Covered​ (B). Heidi​ Høi Jensen, a foreign exchange trader at J.P. Morgan​ Chase, can invest ​$4.9 ​million, or the foreign currency equivalent of the​ bank's short term​ funds, in a covered interest arbitrage with Denmark. She is now evaluating the arbitrage profit potential in the same market after interest rates change.​ (Note that anytime the difference in interest rates does not exactly equal the forward​ premium, it must be possible to make CIA profit one way or​ another.) Arbitrage...
Copenhagen Covered​ (B). Heidi​ Høi Jensen, a foreign exchange trader at J.P. Morgan​ Chase, can invest...
Copenhagen Covered​ (B). Heidi​ Høi Jensen, a foreign exchange trader at J.P. Morgan​ Chase, can invest ​$5 ​million, or the foreign currency equivalent of the​ bank's short term​ funds, in a covered interest arbitrage with Denmark. She is now evaluating the arbitrage profit potential in the same market after interest rates change.​ (Note that anytime the difference in interest rates does not exactly equal the forward​ premium, it must be possible to make CIA profit one way or​ another.) Arbitrage...
Copenhagen Covered​ (B). Heidi​ Høi Jensen, a foreign exchange trader at J.P. Morgan​ Chase, can invest...
Copenhagen Covered​ (B). Heidi​ Høi Jensen, a foreign exchange trader at J.P. Morgan​ Chase, can invest ​$5 ​million, or the foreign currency equivalent of the​ bank's short term​ funds, in a covered interest arbitrage with Denmark. She is now evaluating the arbitrage profit potential in the same market after interest rates change.​ (Note that anytime the difference in interest rates does not exactly equal the forward​ premium, it must be possible to make CIA profit one way or​ another.) Arbitrage...
Copenhagen Covered​ (B). Heidi​ Høi Jensen, a foreign exchange trader at J.P. Morgan​ Chase, can invest...
Copenhagen Covered​ (B). Heidi​ Høi Jensen, a foreign exchange trader at J.P. Morgan​ Chase, can invest $4.9 million, or the foreign currency equivalent of the​ bank's short term​ funds, in a covered interest arbitrage with Denmark. She is now evaluating the arbitrage profit potential in the same market after interest rates change.​ (Note that anytime the difference in interest rates does not exactly equal the forward​ premium, it must be possible to make CIA profit one way or​another.) Arbitrage funds...
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT