Assessment of Potential Arbitrage Opportunities
Recall that Blades, a U.S. manufacturer of roller blades, has chosen Thailand as its primary export target for Speedos, Blades’ primary product. Moreover, Blades’ primary customer in Thailand, Entertainment Products, has committed itself to purchase 180,000 Speedos annually for the next 3 years at a fixed price denominated in baht, Thailand’s currency. Because of quality and cost considerations, Blades also imports some of the rubber and plastic components needed to manufacture Speedos from Thailand.
Lately, Thailand has experienced weak economic growth and political uncertainty. As investors lost confidence in the Thai baht as a result of the political uncertainty, they withdrew their funds from the country. This resulted in an excess supply of baht for sale over the demand for baht in the foreign exchange market, which put downward pressure on the baht’s value. As foreign investors continued to withdraw their funds from Thailand, the baht’s value continued to deteriorate. Since Blades has net cash flows in baht resulting from its exports to Thailand, a deterioration in the baht’s value will affect the company negatively.
Ben Holt, Blades’ CFO, would like to ensure that the spot and forward rates Blades’ bank has quoted are reasonable. If the exchange rate quotes are reasonable, then arbitrage will not be possible. If the quotations are not appropriate, however, arbitrage may be possible. Under these conditions, Holt would like Blades to use some form of arbitrage to take advantage of possible mispricing in the foreign exchange market. Although Blades is not an arbitrageur, Holt believes that arbitrage opportunities could offset the negative impact resulting from the baht’s depreciation, which would otherwise seriously affect Blades’ profit margins.
Holt has identified three arbitrage opportunities as profitable and would like to know which one of them is the most profitable. Thus, he has asked you, Blades’ financial analyst, to prepare an analysis of the arbitrage opportunities he has identified. This would allow Holt to assess the profitability of arbitrage opportunities very quickly.
Ben Holt has obtained several forward contract quotations for the Thai baht to determine whether covered interest arbitrage may be possible. He was quoted a forward rate of $.0225 per Thai baht for a 90-day forward contract. The current spot rate is $.0227. Ninety-day interest rates available to Blades in the United States are 2 percent, while 90-day interest rates in Thailand are 3.75 percent (these rates are not annualized). Holt is aware that covered interest arbitrage, unlike locational and triangular arbitrage, requires an investment of funds. Thus, he would like to be able to estimate the dollar profit resulting from arbitrage over and above the dollar amount available on a 90-day U.S. deposit.
Determine whether the forward rate is priced appropriately. If it is not priced appropriately, determine the profit you could generate for Blades by withdrawing $100,000 from Blades’ checking account and engaging in covered interest arbitrage. Measure the profit as the excess amount above what you could generate by investing in the U.S. money market.
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