Question

(Covered Interest Arbitrage) Harry Norman, a foreign exchange trader at UBS’s office in Tokyo has $2,000,000 or its yen equivalent to invest. He faces the following exchange rates and interest rates. How can he profit from the covered interest arbitrage? Spot rate (¥/$) = 112.20 180-day forward rate (¥/$) 180-day = 109.80 U.S. dollar interest rate 180-day = 4.00% Japanese yen interest rate = 2.00%

Answer 1

Resulting amount after accounting for the interest rate using the US$ 180 day interest rate : $2000000 x 1.04 = $ 2080000

Expected future value after applying 180 day forward rate:-

The initial investment being made by Harry Norman is $2000000. In terms of Yen, using the given spot rate (¥/$) = 112.20, the value of initial investment is:

$2000000 x 112.20 = 224400000

The expected yield can be calculated as:

Hence, the Harry Norman can expect a yield of around 0.75% which is less than his domestic yield. Thus, Harry Norman can generate covered interest arbitrage profits by investing in the lower interest rate currency, i.e. the Yen, and thereafter selling the Yen proceeds forward into dollar at a forward premium which does not completely negate the interest differential.