Question

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 ........?%, Should she borrow Danish Krones or US Dollar? Should she invest the Danish Krones or the US Dollar  in the higher yielding currency for CIA profit? ? (Round answers to three decimal places .)

Answer 1

Answer:

Step 1: $5,000,000 should be converted into Danish Krones using spot exchange rates

Step 2: Danish Krones to be invested at 4.9% annual interest rate for 3 months (effective interest rate = (4.9%/12)*3

Step 3: Invested amount + interest to be converted back in $ using 3 months forward rate

Step 4: Profit = (Invested amount + returns @ 4.9%pa) - (Borrowed funds + Interest rate @ 3%pa)

1. CIA profit potential is $2680.85 or 0.054%
2. She should borrow US $ since the borrowing costs are lower @ 3%
3. She should invest in high yielding Danish Krones