Question

2. Heidi Hoi Jensen, a foreign exchange trader at J.P. Morgan Chase, can invest $5 million, or the foreign currency equivalent of thebank's short term funds, in a covered interest arbitrage with Denmark. Using the following quotes, can Heidi makea covered interest arbitrage (CIA) profit? If yes, then find the arbitrage profit in dollars. Clearly indicate the steps needed to take to realize the arbitrage profit. (Please note that the interest rates are quoted in annual terms, and that the exchange rates are in European terms!) $5,000,000 Arbitrage funds available 6.1722 Spot exchange rate (kr/S) 6.1977 3-month forward rate (kr/S) U.S. dollar annual interest rate 3.050% Danish krone annual interest rate 5.000%

Answer 1

• U.S. dollar interest rate for 3-month = (U.S. dollar annual interest rate) / 4 = (3.050%)/4 = 0.7625%
• Similarly Danish krone interest rate for 3-month = (Danish krone annual interest rate) / 4 = (5.000%)/4 = 1.250%
• Borrow $5,000,000 @ 0.7625% per 3-month which means that the total loan repayment obligation after 3-months would be $5,038,125 ($5,000,000 x [100%+0.7625%]).
• Convert the $5,000,000 into Danish krone (because it offers a higher one-year interest rate) at the spot rate of 6.1722 kr/$ ($5,000,000 x 6.1722 kr/$= kr 30,861,000).
• Lock in the 1.250% rate on the deposit amount of kr 30,861,000, and simultaneously enter into a forward contract that converts the full maturity amount of the deposit (which works out to kr 31,246,763 rounded to nearest kr) into currency U.S. dollar at the 3-month forward rate of 6.1977 kr/$.
• After 3-months, settle the forward contract at the contracted rate of 6.1977 kr/$, which would give the investor $5,041,671 (kr 31,246,763/6.1977 kr/$) (rounded to nearest dollar).
• Repay the loan amount of $5,038,125 and pocket the profit of $3,546 ($5,041,671 - $5,038,125).