Question

3. Assume the following information: Current spot rate of Australian dollar = $.86 Forecasted spot rate of Australian dollar 1 year from now = $.88 1-year forward rate of Australian dollar = $.93 Annual interest rate for Australian dollar deposit = 4% Annual interest rate in the U.S. = 2% What is your percentage return from covered interest arbitrage with $650,000?

Answer 1

Covered Interest Arbitrage Strategy -

1. Borrow money in lower interest rate currency
2. Convert it to higher interest rate currency and invest at higher rate
3. Cover the borrowed amount and interest with Forward rate contract
4. On maturity, Convert the proceeds from investment at Forward rate and payoff the borrowed amount and interest on it. Remaining Amount would be Profit of Covered Interest Arbitrage.

Provided-

Spot rate AD/$ = 0.86

1 year Forward rate AD/$ = 0.93

Australian dollar (AD) interest rate = 4%

Dollar ($) interest rate = 2 %

Amount = $ 650,000

Step-1 Borrow $ 650,000 in dollar

Step-2 Convert it into AD at spot rate i.e 650,000/0.86 = AD 755,813.953488

Step-3 Deposit AD amount at 4%

Step-4 Cover the Borrowed amount and interest i.e 650,000*1.02 = $ 663,000 in Forward contract

Step-5 After one year, proceed from deposit would be 755,813.953488*1.04 = AD 786,046.511627

Step-6 Convert amount in Step-5 into $ at Forward rate that would be 786,046.511627*0.93 = $ 731,023.255813

Step-7 Payoff the borrowed amount with interest i.e $ 663,000 and

Step-8 Remaining amount would be Profit i.e 731,023.255813 - 663,000 = $ 68,023.2558135

Percentage Return from covered interest arbitrage with $ 650,000 = 68,023.2558135/650,000

= 0.10465116279

= 10.47 %