Question

Covered Interest Arbitrage. Assume the following information:

                                                                                                              Quoted Price

                Spot rate of Canadian dollar                                                  $.90

                90‑day forward rate of Canadian dollar                               $.88

                90‑day Canadian interest rate                                                4.4%

                90‑day U.S. interest rate                                                          1.6%

Given this information, what would be the yield (percentage return) to a U.S. investor who used covered interest arbitrage? (Assume the investor invests $1,000,000.) What market forces would occur to eliminate any further possibilities of covered interest arbitrage?

Answer 1

Spot price is 0.9

futures price is 0.88

interest rates in cannada is 4.4%

interest rates in us is 1.6%

according to interest rate parity therom the currency with higher interest rates will sell in discount in futues market to cancel the arbitrage

so CAD will be sold in discount

arbitrage free price is s*(1+rh)/(1+rf)

where s is spot price

rf is foreign interest and rh is home interest

= 0.90*(1.0160)/(1.044) = 0.8758

but quoted futues price is 0.88

now we have 1 million dollars

arbitrage process is sell dollars in futures market and invest in CAD denominated securities

liability in dollars is 1m*(1.016) = 1.016 miilion

cad we receive is 1/0.9 = 1.11111 million

cad we receive after 90 days is 1.11111(1.044) = 1.16 million

dollars we receive is 1.16*0.88 = 1.0208

profit is 1,0208-1.016= 0.0048 million

yield is 0.0048/1% = 0.48%

as long as arbitrage exists investors will try to take the profit so in the process they sell in futures market which is overpriced untill it reaches arbitrage free price