Question

[30] The exchange rate on June 19, 2020, 1 USD against SGD was 1.394. Short term interest rate, in each Singapore dollar and United States dollar are 2.5% and 0.25% respectively. Suppose one year forward rates of Singapore dollar against 1 US Dollar is 1.45.

You are required:

[20] Suppose you want to borrow USD 1,000, could you make a profit or not from an arbitrage in one year later, and how much money you get it?

[10] Based on the information above, is it good or not for economy of Singapore? Give some reasons.

Answer 1

From Covered Interest Arbitrage Argument

Theoretical One year Forward Rate = Spot rate * (1+interest rate in Singapore)/(1+interest rate in USA)

=1.394*1.025/1.0025

= 1.4253

As the actual forward rate is 1.45 and is higher than 1.4253 , there is arbitrage opportunity

The arbitrage can be made by borrowing Singapore Dollar 1394 for one year , converting to USD 1000 at the spot rate, investing the US Dollars at 0.25% p.a.  and selling 1002.50 USD using 1 year forward at the rate of USD 1 = 1.45 SGD

After one year, get USD 1002.50 from Investment in USD, Sell the dollar amount using forward to get SGD 1002.50*1.45 = SGD 1453.625 and pay back SGD borrowings worth SGD1394*1.025 = SGD1428.825 , and make an arbitrage profit of SGD 24.775

b) The more than commensurate devaluation of SGD will be advantageous for exporters but  disadvantageous for Importers of Singapore. Deviations from the required rate generally exist for the short term and hence should not prove to be much disadvantageous to Singapore economy