Question

Given the following information, find the profits you can make using covered interest arbitrage. Assume you can borrow either EUR 100,000 or JPY 14,619,883.04

EUR interest rate = 3.5% per year

JPY interest rate = 0.4530% per year

S (EUR/JPY) = EUR 0.00684 per JPY

F (EUR/JPY) = EUR 0.0074 per JPY for 1 year maturity forward contract.

1. Which currency would you borrow to conduct covered-interest arbitrage?

2. Assume you want your profits in euro, what covered-interest arbitrage profits do you expect in 1 year? Show all the steps involved in the covered-interest arbitrage process.

3. What would be the profits if you realize them in JPY? Show your calculations.

Answer 1

Solution:

Current spot rate =  EUR 0.00684 per JPY

EUR interest rate = 3.5% per year

JPY interest rate = 0.4530% per year

F (EUR/JPY) = EUR 0.0074

Expected Future rate = S0 * ( 1 + Interest rate in Euro ) / (1 +interest rate in Japan)

Expected Future rate = 0.00684 * ( 1 + 3.5% ) / (1+0.4530%) = 0.007047

Part A )

Since expected future rate is EUR 0.007047 / Yen, while forward rate EUR 0.0074 / Yen

Epected future rate < Less than forward rate

In this condition we will have to borrow Euro

Part B )
Borrow UR 100,000 at 3.5% interest. It means that after 1 year we have to pay total of 100,000* (1+3.5%) = 103,500

Now covert this Euro to Japaese yen and current spot price and also buy the forward contract where for every yen we will get 0.0074 Euro

100,000 Euro at 0.00684 Euro/ Yen will become 14,619,883.04 Yen

Now invest this amount in Japan and earn 0.4530% interest

14,619,883.04 * (1+0.4530%) = 14686111.11

Convert this to Euro at 0.074 Euro / Yen

14686111.11 * 0.074 = 108677.22

Profit in Euro = 108677.22 - 103,500 = 5172.22

Part C )

Profit in Yen = Profit in Euro / Exchange rate = 5172.22 /0.0074 = 698,948.65