Question

One year borrowing and deposit interest rates are 10% and 8% respectively in

the US and 8% and 6% respectively in Spain. The spot exchange rate for the

US dollar is $1.25 to the EURO. The 12-month forward rate is $1.30

i) Assuming you do not have any initial investment funds, suggest a way you

might profit from the pricing inconsistency presented above.

(ii) Explain why some of the figures in the question of borrowing and deposit rates are not used.

Answer 1

12 month forward rate ($ 1.30) of $ is higher than the spot rate ($ 1.25).

This implies that the € is at premium

premium % = (1.30 - 1.25)/1.25 * 100

= 0.05/1.25*100

= 4%

Interest rate differential = 8% - 8% = 0

Since interest rate differential (0%) and premium % (4%) do not match, there are arbitrage gain possibilities. An arbitrage can take the following steps in this regard.

(i) The arbitrageur borrows $100000 at 10% for 12 months @ 10% interest rate.

(ii) He converts $100000 at the spot rate of $ 1.25 = € 80000

(iii) He invest that amount @ 8% as a result of this investment, he obtains interest of € 80000*6% = 4800

(iv) Total sum available with the arbitrageur, three months from now is 80000 + 4800 = € 84800

v) he can purchase $ from this rupees at 12month forward rate which is€ 1 = $ 1.30= 84800*1.30 = 110240

(vi) total amount to be return in $ = 100000 + 100000*10% = $ 110000

(vii) Net gain is = 110240 - 110000

= $ 240

(ii) if you borrow funds in $ the banks will charge rate @ 10% as it is the ask rate of bank as bank will give lend fund always at higher interest rates than deposit rate therefore deposit rate of $ bank is of no use.

and we deposit the money which borrow in $, in Spain at 6% as bank gives you lower interest rate.

so lending interest charges of amercian bank & borrowing interest charge of spain bank is of no use.

Please check with your answer and let me know.