Question

Prestige International, a swiss watch manufacturer exports sports and premium wrist and smart watches to the U.S. In early 2012, the spot exchange rate between the Swiss Franc and U.S. dollar was 1.0404 ($ per franc). While they are usually happy about their exports being billed in US Dollars, but due to the recent fluctuation in exchange rates, the company has taken a toll on their net receipts when converted into Swiss Francs.

Interest rates in the U.S. and Switzerland were 0.25% and 0% per annum respectively, with continuous compounding. The three-month forward exchange rate was1.0300 ($ per franc).

Ms. Saleha, the CFO of the company has asked you to devise strategy where arbitrage is possible on the current scenario. What arbitrage strategy was possible? How does your answer change if the exchange rate is 1.0500 ($ per franc).

Answer 1

Interest for 3 months

=1.0404*.25%*3/12=0.00065

Value after 3 months=1.0404+0.00065=$1.04105

forward exchange rate was1.0300

Arbritage gain=$1.04105 -$1.0300=$0.01105

Yes,arbitrage strategy is  possible.

Cash future arbitrage is basically an opportunity to earn risk-free profit from an unusual difference between cash and future prices in the stock market. There is normally an appreciable and exploitable difference between the Cash price and future price, especially at the beginning of the month.

Arbitrage opportunities exist as a result of market inefficiencies, which allow investors to exploit price differences. Therefore it is not limited to just investments in stocks, but really any market where such opportunities exist.

• Arbitrage occurs when a security is purchased in one market and simultaneously sold in another market, for a higher price.
• The temporary price difference of the same asset between the two markets lets traders lock in profits.
• Traders frequently attempt to exploit the arbitrage opportunity by buying a stock on a foreign exchange where the share price hasn't yet been adjusted for the fluctuating exchange rate.
• An arbitrage trade is considered to be a relatively low-risk exercise.

Arbitrage is considered a risk-free profit for the investor or trader. A trader tries to exploit arbitrage opportunities like buying a stock on a foreign exchange where the price hasn't yet adjusted for the fluctuating exchange rate.

if exchange rate is 1.0500

then Loss =$1.04105 -$1.0500=$0.01105=$(0.00895)