Question

1. Short-term interest rate in Indonesia and the United States are 6.5% and 1% respectively. The current exchange rate on June 15, 2020 is 14,010 Rupiah against US Dollar. Suppose a forward exchange rate at 15,000 Rupiah against US Dollar.
   You are required:­

1. Based on your calculation, Could you take a profit from an arbitrage?

Answer 1

The interest rate in Indonesia: 6.5% and Interest Rate in United States:1%.

Given that "Forward exchange rate": 15,000 Rupiah per USD.

"Spot exchange rate": 14,010 Rupiah per USD

We know that, as per Interest Rate Parity Theory:-
(Forward Rate Rupiah/$) / (Spot Rate Rupiah/$) = (I+Intt Rupiah) / ( 1+ Intt $)

(Forward Rate Rupiah/$) / 14,010 Rupiah = (I+ 0.065) / ( 1+ 0.01))

(Forward Rate Rupiah/$) / 14,010 Rupiah = 1.065/1.01

(Forward Rate Rupiah/$) / 14,010 Rupiah = 1.05445

Forward Rate Rupiah/$= 1.05445 * 14,010 Rupiah

Forward Rate Rupiah/$= 14,772.80 Rupiah

(as calculated on the basis of Interest rate parity theory)

Hence, based on our calculation, we can make a profit from an arbitrage by selling Forward contract at 15,000 rupiahs, since its parity value is 14,772.80 rupiah and it is overvalued at this time.

(Please provide your valuable feedback and feel free to ask if have any query. Thank You)