Question

Robert is considering an investment opportunity based on the information provided in the table below. Explain the steps...

Robert is considering an investment opportunity based on the information provided in the table below. Explain the steps she has to undertake in order to earn a risk-free profit by engaging in a forward contract.

USD 6-month risk free rate 2.45%
EUR 6-month risk free rate 3.60%
EUR/USD Spot exchange rate 1.1278
EUR/USD 6-month forward rate 1.1480
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Answer #1
1) The 6 month forward premium for the USD = 1.1480/1.1278-1 = 1.79%
2) Interest rate differential = 3.60%-2.45% = 1.15%
3) As the 6 month forward premium is not equal to
the 6 month interest rate differential, there is
scope for covered interest rate arbitrage.
4) As the interest rate differential is less than the
forward premium, borrowing should be made in
the currency having higher interest rate and the
investment should be made in the currency having
lower interest rate.
Steps to be taken on Day 1 are:
*Borrow in euro at 3.60% for 6 months
*Convert the borrowed in euros into $ at the spot
rate of 1.1278.
*Invest the dollars so got at 2.45% for 6 months.
*Enter into a 6 month forward contract to sell the
dollars invested in the previous step (including
interest at 2.45%)
Steps to be taken after 6 months are:
*Realize the dollar deposit along with interest
*Convert it into euros at the forward contract rate
*Pay the euro loan along with interest using the
euros got in the previous step.
*The euros remaining after repaying the loan with
interest is the profit from the covered interest rate
arbitrage.
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