Question

Heidi​ Høi Jensen, a foreign exchange trader at J.P. Morgan​ Chase, can invest ​$5 million, or the foreign currency equivalent of the​ bank's short term​ funds, in a covered interest arbitrage with Denmark. Using the following​ quotes, can Heidi make a covered interest arbitrage​ (CIA) profit? If yes, then find the arbitrage profit in dollars. Clearly indicate the steps needed to take to realize the arbitrage profit. (Please note that the interest rates are quoted in annual terms, and that the exchange rates are in European terms!)

Arbitrage funds available		$5,000,000
Spot exchange rate (kr/$)		6.1722
3-month forward rate (kr/$)		6.1977
U.S. dollar annual interest rate		3.050%
Danish krone annual interest rate		5.000%

Answer 1

US Annual Interest Rate = 3.05 % and Danish Annual Interest Rate = 5 %

3-month US Rate = 3.05 / 4 = 0.7625 % and 3-month Danish Rate = (5/4) = 1.25 %

Arbitrage Fund Available = $ 5000000 and Current Spot Rate = 6.1722 kr / $

Covered Interest Arbitrage can be executed as described below:

- Borrow $ 5000000 at the US interest rate of 3.05 % per annum for 3 months. This borrowing creates a repayment liability = 5000000 x (1.007625) = $ 5038125

- Convert the $ borrowing into kr at the spot rate of 6.1722 kr / $ to yield = (5000000 x 6.1722) = 30861000 kr

- Invest (lend) the kr proceeds at the Danish Rate of 5 % per annum for 3 months. After, 3 months this lending yields value = 30861000 x (1.0125) = 31246763 kr

- Convert the Investment Proceeds into $ at the 3-month forward rate of 6.1977 kr / $ to yield = 31246763 / 6.1977 = $ 5041671

- Covered Interest Arbitrage Profit = Investment Proceeds in $ - Repayment Liability in $ = 5041671 - 5038125 = $ 3545.7 ~ $ 3546