Question

Due 12/1/2019 DY Mum 1. Assume the following information Spot rate of Canadian dollar may in 90-day forward rate of Canadian dollar $0.80 So American aunts Duration1 A 5.79 90-day Canadian lending interest rate 4% 90-day Canadian borrowing interest rate 4.5% forward to bring 90-day U.S. lending interest rate 2.25% 90-day U.S. borrowing interest rate 2.5% -B back man a . Given this information, what is the appropriate covered interest arbitrage strategy? (Should you borrow in Canada and save in the U.S. or vice versa?) may B money to A ward contract off debt b. What market forces would occur to eliminate any further possibilities of covered interest arbitrage? c. What does the 90-day forward rate tell you about the expected future spot rate?

Answer 1

A. (i) Covered interest arbitrage if we borrow in U.S for 90 days

• Borrow 1$ @ 2.5% for 90 days
• Convert 1$ into 1.25 Can$ (1 Can$=0.8$)
• Invest 1.25 Can$ @4% for 90 days
• Realize investment after 90 days = 1.25*1.01= 1.2625 Can$
• Convert the realization to $ = 1.2625*0.79= 0.9974$
• Repay borrowing= 1*1.00625= 1.00625$   

(ii) Covered interest arbitrage if we borrow in canada for 90 days

• Borrow 1 Can$ @ 4.5% for 90 days
• Convert 1 Can$ into 0.8 $ (1 Can$=0.8$)
• Invest 0.8 $ @2.25% for 90 days
• Realize investment after 90 days = 0.8*1.005625= 0.8045$
• Convert the realization to Can $ = 0.8045/0.79= 1.018 Can$
• Repay borrowing= 1*1.125= 1.125 Can$

Hence there is no arbitrage whether we borrow in US &save in Canada or vice versa

B. Further in a two way quote the spread between the bid rate & offer/ask rate eliminates the possibility of arbitrage.

C. the 90 day forward rate is 1 Can$= 0.79$ when the spot rate is 1 Can$=0.8$

This suggests that the Can$ is trading at discount against the $.