Question

Currently, the spot exchange rate is €1=$2 and the six month forward exchange rate is €1=$2.5. The six-month interest rate is 5% in the U.S. and 3% in the Germany. Assume that you can borrow as much as $1,000,000. Determine whether you can carry out a covered interest arbitrage. Show all the steps and the arbitrage profit if there is any.

Answer 1

Amt borrowed in USD = $1000000 Interest rate in US 5% Interest rate in Germany- 3%. Exchange Rates Spot Rate : €1 = $2 6-Month forward Rate : € 1 = $ 2.50 Following are the assumptions made Borroming Rate and Deposit rates in both countries is the same Based on Interest Rate Party Theorem - Expected Spot After 6- Months Base Currency * ( 1 + Int. rate of Base cumenty o ency) - it Int rate of Foreign currency 2 x (1+[0.05x6/12] (1+[0.03x6/13) 13 2 x 1.025 1.015 1 2.0197 Pg

But 6- Month forward is given as €! = $2.50 Based on above we can take following steps – Borrow $1000,000 in US. We will be obligated to repay $10,25,000 after 6 months. © convert $10,00,000 in Euros and deposit the amount in Germany for six months Amt in Euros = € 5,00,000 [ $1000.000 2 Amt after 6 months = €5,00,000 [1+ 1.015] =€ 5,07500 Amt after 6 months = € 5,07500 x 2.50 in USD (Forward Rate 6-Months) $12,68,750 Enter into a forward contract for 6- Month forward sell amount earned in Euros after 6 months i. Arbitrage Profit = Pay in - Pay out = $12.68.750 -$10.25,000 - $ 2,43,750 pg @