Question

You have AU$ 1.000.000

Explain how can you make profit using interest arbitrage.

Outline various market conditions where making profit is impossible.

Answer 1

Considering a market condition where AU$ 1000000 has two investment oppurtunities :

(a) He can invest in his home currency which is giving 5% interest rate for 3 months

(b) he can invest in Japanese Yen which is giving 1% p.a ( Considering exchange rate 100 yen/dollar.)

The first investment oppurtunity yields a future value of $1012500

If we consider the second option we have to invest 1 million dollar into Yen at the spot rate of 100 Yen/ dollar and he invest 100 million Yen.

Simultaneously a covered arbitrage contract which is a forward contract is included which gurantees a 99 Yen/dollar. This arbitrage contract hedges the spot market risk.

So the future value of second investment is 100250000 Yen (Converting at the rate of 99 Yen/dollar the value is $1012626)

Comparing both the investment a profit of $ 126 (arbitarge value)

Some of the Market conditions where profit making is impossible:

1.Without a covered forward contract the investment is exposed to spot risk and profit making seems challenging if the currency is weak.

2. Arbitrage are complex and doesnot gurantee profitable returns.

3. If the cost of hedging is more than the interest differential rate there is no profit making