Question

In: Finance

Takeshi Kamada, Credit Suisse (Tokyo), observes that the ¥/$ spot rate has been holding steady, and...

Takeshi Kamada, Credit Suisse (Tokyo), observes that the ¥/$ spot rate has been holding steady, and both dollar and yen interest rates have remained relatively fixed over the past week. Takeshi wonders if he should try an uncovered interest arbitrage (UIA) and thereby save the cost of the forward cover. Many of Takeshi's research associates- and their computer models- are predicting the spot rate to remain close to ¥/$ 118.00 for the coming year. Using the data below, calculate the UIA profit potential (in yen). (round to two decimal places).

Arbitrage funds available $5,000,000 or its Yen equivalent

Spot rate ¥/$ 118.60

360 day Forward rate ¥/$ 117.80

Expected spot rate in 360 days ¥/$ 118.00

U.S. dollar annual interest rate 2.4%

Japanese yen annual interest rate 1.7%

Solutions

Expert Solution

Funds Taken as loan (in Yen)         593,000,000
Interest paid on loan 1.70%
[A] Amount after 360 days to be returned (in Yen)         603,081,000
Spot Rate                   118.60
Funds Taken as loan (in Dollar)              5,000,000
Interest earned on deposit 2.40%
Amount after 360 days in deposit (in Dollar)              5,120,000
Exchange Rate after 360 days 117.80
[B] Amount after 360 days in deposit (in Yen)         603,136,000
Profit Potential (in Yen) = B - A                55,000

UIA is all about arbitrage on interest rate differentials & exchange price movements. So, we take loan in a currency(lower interest rate currency) & put a deposit in higher interest rate currency. We earn due to interest rate difference. When we convert back to the loan taking currency, we are exposed to exchange price. Here we take loan of 593 Mn in Yen(equivalent to 5 Mn in Dollar). Then , calculate interest to be paid & earned. Finally use the forward rate after 360 days to make profit.


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