Question

Robert is considering an investment opportunity based on the information provided in the table below. Explain the steps she has to undertake in order to earn a risk-free profit by engaging in a forward contract.

USD 6-month risk free rate	2.45%
EUR 6-month risk free rate	3.60%
EUR/USD Spot exchange rate	1.1278
EUR/USD 6-month forward rate	1.1480

Answer 1

1)	The 6 month forward premium for the USD = 1.1480/1.1278-1 =	1.79%
2)	Interest rate differential = 3.60%-2.45% =	1.15%
3)	As the 6 month forward premium is not equal to
	the 6 month interest rate differential, there is
	scope for covered interest rate arbitrage.
4)	As the interest rate differential is less than the
	forward premium, borrowing should be made in
	the currency having higher interest rate and the
	investment should be made in the currency having
	lower interest rate.
	Steps to be taken on Day 1 are:
	*Borrow in euro at 3.60% for 6 months
	*Convert the borrowed in euros into $ at the spot
	rate of 1.1278.
	*Invest the dollars so got at 2.45% for 6 months.
	*Enter into a 6 month forward contract to sell the
	dollars invested in the previous step (including
	interest at 2.45%)
	Steps to be taken after 6 months are:
	*Realize the dollar deposit along with interest
	*Convert it into euros at the forward contract rate
	*Pay the euro loan along with interest using the
	euros got in the previous step.
	*The euros remaining after repaying the loan with
	interest is the profit from the covered interest rate
	arbitrage.