Question

Question 1

(a) One year borrowing and deposit interest rates are 12% and 10% respectively in the US and 10% and 8% respectively in Switzerland. The spot exchange rate for the US dollar is $8 to the Swiss Franc. The 12-month forward rate is $8.5. Suggest a way you might profit from the pricing inconsistency that is presented here, assuming you have no initial investment funds.

(b) One year borrowing and deposit interest rates are 12.5% and 10.5% respectively in the US and 10.5% and 8.5% respectively in Spain. The spot exchange rate for the
US dollar is $1.50 to the EURO. The 12-month forward rate is $1.55. Assuming you do not have any initial investment funds, suggest a way you might profit from the pricing inconsistency presented above.

Answer 1

a.Here since the borrowing rates and deposit rates are different in two countries,we can earn profits by difference in such interest rates by following arbitrage method. i.e borrow in a country and invest in different country so that you can earn profits through indifference in interest rates

For example, borrow 100000 us dollars for 12 months with interest rate of 12% and convert it into swiss franc and invest it in swiss franc for 12 months with interest rate of 8% and after the end of  12 months convert it into dollars and repay the loan taken in us dollars along with interest

convert 100000 dollars into swiss franc using spot rate of $8 for swiss franc

we get 12500 swiss franc and invest it into swiss franc and at the end of 12 months we get 13500 swiss franc

convert these 13500 swiss franc into dollars using 12 months forward rate of $8.5 to swiss franc

we get 114750 dollars and repay the loan amount along with interst rate which is 112000

therefore the remainning 114750-112000 i.e 2750 dollars is profit to you

b.By following the same concept, borrow 100000 us dollars with interest rate of 12.5% and convert it into euro by using spot rate of $1.5 to euro and invest it into euros with interest rate of 8.5%

Then we get 66667 euros and after 12 months we receive 72334 euros

and by converting it with forward rate which is $1.55 to euro, we get 112117 dollars

amount to be repay =112500 dollars

therefore by this process we get loss of 383 dollars

Therefore it is advicable not to enter into this contract