Question

Consider the following information available in the Citadel Bank: Spot Rate for the Canadian Dollar $0.80 180 – day forward rate of the Canadian Dollar $0.79 180 – day Canadian interest rate 4% 180 – day U.S. interest rate 2.5% (a)Given this information, would it be a prudent strategy to engage in covered interest arbitrage? Explain (b)If covered interest arbitrage is profitable how much profit would an investor earn if he/she uses $1,000,000? (c)Briefly discuss the realignment process the will yield interest rate parity.

Answer 1

	Forward rate= USD per CD* (1+Interest rate in USA)/(1+Interest rate in Canada)
	Forward rate=	=0.8*(1+0.025)/(1+0.04)
	Per USD	0.7885
	Since given forward rate is also 0.79, we can see that there is some arbitrage opportunity is not available
	So the funds available are invested in Canada
	Equivelent Canadian Dollars	=1000000/0.8
		1250000
	This is invested in Canda for 90 days	=1250000*(1+4%)
		1,300,000
	Amount converted back to USD	=1300000*0.79
		1,027,000
	Amount in USD if invested in USA	=1000000*(1+2.5%)
		1,025,000
	So this way there will be Gain of	2,000