Question

In: Finance

A currency trader can borrow the equivalent of $1,000,000 (in either $s or €s) for one...

A currency trader can borrow the equivalent of $1,000,000 (in either $s or €s) for one year. The one-year $US interest rate is 2%; the one-year Euro interest rate is 6%. The spot rate is $/€ 1.25 and the one-year forward rate is $/€ 1.20.

How much profit can be realized via covered interest arbitrage?

Expert Solution

Step 1 : Borrow euro equal to $ 1000000

Borrow amount = 1000000 / Spot rate

= 1000000 / 1.25

= 800000 Euros

Outflow after 1 year = Borrow Amount * ( 1 + interest rate )

= 800000 * ( 1 + 0.06 )

= 848000 euros

Step 2 : Invest in dollar

In flow after year 1 = Investment Amount * ( 1 + interest rate )

= 1000000 * ( 1 + 0.02 )

= $ 1020000

Step 3 : Convert into Euros

Inflow ( in Euros ) = 1020000 / Forward rate

= 1020000 / 1.2

= 850000 Euros

Step 4 : Arbitrage profit

Profit = Inflow - Outflow

= Step 4 - Step 1

= 850000 - 848000

= 2000 Euros Answer

Hope you understand the solution.

jeff jeffy answered 1 year ago

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