Question

The Brennon Group is a U.S. hedge fund that wants to benefit from the interest rate differential between the euro area and Japan. A euro (€) costs $1.07 today, while a yen (¥) costs $0.0088 today. The fund expects the exchange rates to still be $1.07 per euro and $0.0088 per yen in 5 months. Current annual interest rates are as follows:

Currency Euro Yen

Borrowing rate 7.5% 6.8%

Lending rate 4.7% 4.3%

The fund doesn't want to invest any of its own money, but can borrow €10,000,000 or ¥1,000,000,000. Assume there are 30 days in every month and 360 days per year. Ignore compounding when working with the interest rates.

Answer 1

Since there is no FFR, so there is chance to gain because of Interest rate parity theory.

Assume,

Situaion1-Brennon Group like to borror EURO and Lend in YEN:

Spot- Borrowing Euro 10,000,000 (In US dollor- 10,700,000)

Interest payable (7.5%) - Euro312,500

Payable after 5 Months- Euro1,0312,500. ( US Dollar 11,034,375)

Spot- Lend Yen - Euro10,000,000*1.07/.0088= Yen 121,590,9090

Interest receivable on Yen= 4.3% = 21785037.86

Receivable in Yen = Yen 1237694127.86 (US Dollar- 10,891,708.32)

Situation 2: Brennon want to borrow in yen and lend EURO.

Borrowing Yen- 1,000,000,000( US dollar require $88,000,00)

Interest Payable- 6.8% p.a.  YEN 28,333,333.33

Total Yen Payable after 5months- YEN1,028,333,333 (US dollar require- $9,049,99)

Lend in EURO - YEN 1,000,000,000* .008224 = EURO 82,24,299.

Receivables in EURO- 4.7% Euro 161,059

Receivables in EURO- EURO 83,85,358 (US dollar to be received- $8,972,333)