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10 points 18. James Chang, a foreign exchange at J.P. Morgan Chase, can invest €100 million or £100 million of the bank's short-term funds in coverage interest arbitrage with the Euro. He has the following quotes. Spot exchange rate E1230/ 180-day forward rate EL 250/E 180-day euro interest rate 3.00% per year (1.5% for 180 days) 180 day pound interest rate 4.00% per year (2.0% for 180 days) Clearly explain how James Chang can make a covered interest arbitrage Pos 9 2 7 $1, 300.873 x 1.07 382,926, 8129127 2.9.26,829:27 X 1.25 : 1031658 1 -101,500,000 10 points The United States runs a significant trade deficit with the rest of the world. Explain how this imbalance should be corrected under: c) A fixed rate regime? . A floating rate regime? currency USD. © Depreciatia ting its a The market would corrected it in anatural way.by reducing usd valve against its currency.

Answer 1

Answer-18

Spot exchange rate                                                       €1.230/£

180-day forward rate                                                     €1.250/£

180 day euro interest rate 3.00% per year (1.5% for 180 days)

180 day pound interest rate 4.00% per year (2.0% for 180 days)

In this question, covered interest arbitrage can be done for making profits. Since, Pound is getting strong as per 180 days forward rate, so the investor should invest in pounds by converting €100,000,000 into pounds.

Euro repayable after 180 days (including interest)

  =             €100,000,000 + (€100,000,000 x 1.5%)

                                                                =             €101,500,000     

Conversion of €100,000,000 into £ using spot rate       = €100,000,000/€1.230

                                                =             £81,300,813

This £81,300,813 will be invested at the interest rate of 2% for 180 days resulting which the amount to be received after 180 days would be:

                                                                =             £81,300,813 + (£81,300,813 x 2%)

                                                                =             £82,926,829

This amount of £82,926,829 would be converted into Euro using 180 days forward rate resulting which the amount to be received would be:

                                                                =             £82,926,829 x €1.250

                                                                =             €103,658,536

As per covered interest arbitrage, after 180 days the Euro receivable is €103,658,536 and the Euro payable is €101,500,000 (as calculated above).

Therefore the arbitrage profit would be €2,158,536.