Question

Assume that annual interest rates are 8 percent in the United States and 7 percent in Turkey. An FI can borrow (by issuing CDs) or lend (by purchasing CDs) at these rates. The spot rate is $0.6661/Turkish lira (TL).

a.	If the forward rate is $0.6735/TL, how could the bank arbitrage using a sum of $9 million? What is the spread earned? (Do not round intermediate calculations. Round your answer to 4 decimal places. (e.g., 32.1616))

Spread earned

%

b.	At what forward rate is this arbitrage eliminated? (Do not round intermediate calculations. Round your answer to 5 decimal places. (e.g., 32.16161))

Forward rate

/TL

Answer 1

a). Borrow $1,000,000 in U.S. by issuing CDs

⇒Interest and principal at year-end = $1,000,000 x 1.08 = $1,080,000

Make a loan in Turkey

⇒Interest and principal = [$1,000,000/0.6661] x 1.07 = TL1.61m

Purchase U.S. dollars at the forward rate of $0.6735 x 1.61m = $1,081,887.10

Profit = $1,081,887.10 - $1,080,000 = $1,887.10

b). F_t = S_t x [(1 + rUS) / (1 + rTL)]

= 0.6661 x [1.08 / 1.07] = $0.6723/TL