Question

Chapter 6 Exchange Rate Interest Rate APR So($/€) $1.45 = €1.00 is 4% F360($/€) $1.48 = €1.00 ie 3% Please note that your answers should include currency symbols ($, €). (a) Find the 1-year forward exchange rate in $ per € that satisfies IRP (b) How would you carry out covered interest arbitrage? Show all the steps and determine the arbitrage profit. 00.13 = 0 albero di om b re 00.19 = 22.1 xs loge in SAT 200.19 = 02.123 igen diw 02a co c o o no momento How to c io' 0.57 3.0 on ero costansiq sdn on o stati bos sule in odsotno s (c) Explain how IRP will be restored as a result of covered arbitrage activities. og t inovo land Strogo na la

Answer 1

a]	1-Year forward exchange rate $/Euro = 1.45*1.04/1.03 =	1.4641
b]	As the forward rate is different from the rate per IRPT,
	covered interest rate arbitrage is possible.
	Forward premium = 1.48/1.45-1 =	2.07%
	Interest rate differential = 4%-3% =	1.00%
	AS the interest rate differential is less than the forward
	premium, it would be advantageous to borrow in the
	currency having higher rate of interest and then
	investing in the currency having lower interest rate.
	The steps would be:
	Let us presume the amount to be borrowed is $10000
	for 1 year, the maturity value of the loan being 10000*1.04 =	$     10,400.00
	The $10000 is to be converted to Euro at spot to get 10000/1.45 =	€       6,896.55
	The Euro 6896.55 would be invested for 1 year to get 6896.55*1.03 =	€       7,103.45
	A forward contract to be entered for the sale of 7103.45 euros after
	1 year to get 7103.45*1.48 =	$     10,513.11
	After 1 year the deposit in Euro with maturity value of Euros 7103.45
	will be realized, then converted at the forward rate to get $10513.11.
	Those dollars would be used to pay the dollar loan which, will have
	a maturity of $10400 in 1 year.
	The extra $s remaining of 10,513.11-10400 = $113.11, would be the
	arbitrage profit.
c]	As more and more people would be converting $ into Euros, the
	spot rate for euro will go up. Similary, the forward rate for Euros
	will go down. The process will be repeated till the arbitrage
	advantage beccomes 0.