Question

Suppose that the current exchange rate is SF1.25/$ and three month forward exchange rate is SF1.30/$. The three-month interest rate is 4 percent per annum in United States and 8 percent per annum in Switzerland. Assume that you can borrow up to $1,000,000 or SF 1,250,000.

a) Is Interest Rate Parity holding?

b) If your answer to part a is no, how would you realize a certain profit via a covered interest arbitrage? Also determine the size of the arbitrage profit.

Answer 1

Ans : Computation of 3 mnth forward rate using interest rates

	Swiss Franc	USD
Spot Rate	1.25	1
Interest Rate	8%p.a	4% p.a
3 mnth Forward Price	1.275 [1.25 + (1.25 * 8% * 3/12)]	1.01 (1 + (1 * 4% * 3/12) ]
3 mnth Forward Rate	1.2624 (1.275 / 1.01)	1

a) Since the derived 3mth Forward rate (SF1.2624/$) and the market 3mth forward rate (SF1.25/$) are different, thus Interest Rate Parity is not holding

b) Assumed borrowed SF1,250,000 @ 8% p.a.
i) Will sell SF and buy $ in the market at spot rate of SF1.25/$ = Receive $1,000,000

ii) Invest $1,00,000 in the US market for 3 mnths @ 4% p.a.

iii) Enter into 3mnth forward USD Sell contract at SF 1.30 / $ for $1,010,000

After 3 Months

Interest on Investment = $1,000,000 * 4% * 3/12 = $10,000
Receive = $1,000,000 + $10,000 = $1,010,000

Will sell $1,010,000 at Forward Rate SF1.30/$ = Recevie SF1,313,000

Pay borrowing with 8% interest = SF 1,250,000 + (SF 1,250,000 * 8% * 3/12) = SF1,275,000

Arbitrage Gain = SF1,313,000 - SF1,275,000 = SF 38,000