Question

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Assume the following information: 1-year interest rate on U.S. dollars = 11.4% 1-year interest rate on...

Assume the following information:

1-year interest rate on U.S. dollars = 11.4%
1-year interest rate on Singapore dollars = 9.1%
Spot rate of Singapore dollar = 0.4 USD/SGD
1-year forward premium on Singapore dollars = 3.79%

Given this information, how much profit can be made with covered interest arbitrage, by borrowing 1 million USD?

Solutions

Expert Solution

As per covered interest arbitrage the currency with higher interest rate will depreciate in future and currency with lower interest rate will appreciate.

In the above question 1 SGD = 0.4 USD or we can re write it as 1 USD = 1/0.4= 2.5 SGD

Simply 1 USD = 2.5 SGD

Now forward premium of SGD is given as 3.79% means in 1 year time SGD will appreciate to 0.4*1.0379= 0.41516 USD per SGD note first you have to pay 0.4 USD for 1 SGD now you will be paying 0.41516 USD per SGD meaning SGD is costlier now or it has appreciated.

Calculation of profit

Borrow 1 million USD at 11.4% and after 1 year pay 1,114,000 USD. Invest borrowed USD 1,000,000 in SGD first convert using spot rate 1,000,000/0.4= SGD 2,500,000 and invest SGD 2.5 Million at 9.1% and get after 1 year SGD 2,500,000 *1.091 = SGD 2727500.

Now convert 2727500 SGD using forward rate of 0.41516 comes to 2727500*0.41516= USD 1132349 Now out of USD 1132349 Pay 1 million USD including interest that is 1114000 and get profit of 1132349-1114000= USD 18349.

jeff jeffy answered 1 year ago
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