Question

Please Show all work please so I can understand.

Given the following information, find the profits you can make using covered interest arbitrage. Assume you can borrow either EUR 100,000 or JPY 14,619,883.04

EUR interest rate = 3.5% per year

JPY interest rate = 0.4530% per year

S (EUR/JPY) = EUR 0.00684 per JPY

F (EUR/JPY) = EUR 0.0074 per JPY for 1 year maturity forward contract

a. Which currency would you borrow to conduct covered-interest arbitrage?

b. Assume you want your profits in euro, what covered-interest arbitrage profits do you expect in 1 year? Show all the steps involved in the covered-interest arbitrage process.

c. What would be the profits if you realize them in JPY? Show your calculations.

Answer 1

a. We should borrow in Euro to conduct covered-interest arbitrage because the EURO is depreciating by around 8% which is more than the interest rate differential of around 3%. Thus borrowing in Euro will lead to profits.

b. Covered-interest arbitrage process

Borrow in EUR	1,00,000	EUR	Liability after 1 year	1,03,500	EUR
Convert to JPY	1,46,19,883	JPY
Lend JPY to get	1,46,86,111	JPY	after 1 year
At the same time get into the forward contract to lock the conversion rate.
Convert to EUR	1,08,677.22	EUR	Profit (less liability)	5,177	EUR

c. To realize profits in JPY

Borrow in EUR	1,00,000	EUR	Liability after 1 year	1,03,500	EUR
Convert to JPY	1,46,19,883	JPY
Lend JPY to get	1,46,86,111	JPY	after 1 year
At the same time get into the forward contract to lock the conversion rate.
Convert JPY worth liability to EUR
	1,39,86,486.49	This will help cover the liability
Remaining JPY	6,99,625	which is the Profit realized

c.