Question

The following are quotes for several U.S. currency dealers.

Dealer	A	B	C	D	E
Japanese yen	109.03 109.06	109.04 109.08	109.06 109.10	109.05 109.07	109.07 109.09
British pounds	1.3115 1.3119	1.3118 1.3120	1.3115 1.3118	1.3116 1.3117	1.3115 1.3118

Covered interest arbitrage (Inter-temporal) - assume that the highest bid and lowest ask are equal (i.e., that the bid-ask spread is zero)

9. Assume the interest rate of 1-year risk free debt denominated in US dollars is 2.57% and the interest rate on 1-year risk free debt denominated in Uruguayan pesos is 9.25%. If the spot market exchange rate for the Uruguayan peso (USD/UYU) is 32.545, what is the 1-year forward exchange rate if interest rate parity holds?

10 a. If the actual 1-year forward exchange rate for Uruguayan pesos is 34.636 and the spot market exchange rate and interest rates are as indicated in question 9, what trades should you make to take advantage of the arbitrage opportunity? Be specific about both current and future transactions (i.e., be sure to specify what currency/currencies are involved and how, and the amount of each – you can make any assumption you like about the amount of currency to start).

b. How profitable is the trade? (State the profitability, either in dollars or pesos, or as a percent of initial amount borrowed.)

Answer 1

For Parity to hold

1 year forward exchange rate = Spot rate(1+ interest rate of USD)/(1+interest rate of uruguayan)

= 32.545*1.0257/1.0925

= 30.555