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14 Aug 2019

2. Suppose that the annual interest rate is 2.0 percent in the United States and 4 percent in Germany, and that the spot exchange rate is $1.60/€ and the forward exchange rate, with one-year maturity, is $1.58/€. Assume that an arbitrager can borrow up to $1,000,000 or €625,000

a. Determine whether the interest rate parity is currently holding.

b. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps and determine the arbitrage profit.

A. $238.65 B. $14,000 C. $46,207 D. $7,000

Circle the correct answer above and provide the workings to the answer above here:

c. Explain how the IRP will be restored as a result of covered arbitrage activities.

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Jarrod Robel
Jarrod RobelLv2
16 Aug 2019

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Suppose that the current spot exchange rate is €1.50/₤ and the one-year forward exchange rate is €1.58/₤. The one-year interest rate is 6.0% in euros and 5.2% in pounds. You can borrow at most €1,000,000 or the equivalent pound amount, i.e., ₤666,667, at the current spot exchange rate.

i. Show how you can realize a guaranteed profit from covered interest arbitrage. Assume that you are a euro-based investor. Also determine the size of the arbitrage profit. 

ii. Discuss how the interest rate parity may be restored as a result of the above transactions. 

iii. Suppose you are a pound-based investor. Show the covered arbitrage process and determine the pound profit amount.

1. a foreign exchange trader for Green Valley Capital, are exploring covered interest arbitrage opportunities between Euros and US Dollars ($) for the next 60 days. You have 1million euros or $ 1.1 million at the current spot rate for the covered interest arbitrage and face the following quotes:

Arbitrage fund availabe 1,000,000 euros or $1,100,000

Spot exchange rate $ 1.1000/€

60-day forward rate $1.1050/€

US Dollar annual interest rate 2.4%

Euro annual interest rate 0.84%

A) what is the annual effective US dollar interest rate from Euro investement?

B) Show the steps and calculate the amount of the covered interest arbitrage profit.

c) determine a theoretical 60-day forward rate (round to 4 decimal places) that will result in a zero covered interest arbitrage profit.

1. a foreign exchange trader for Green Valley Capital, are exploring covered interest arbitrage opportunities between Euros and US Dollars ($) for the next 60 days.

You have 1million euros or $ 1.1 million at the current spot rate for the covered interest arbitrage and face the following quotes:

Arbitrage fund availabe 1,000,000 euros or $1,100,000

Spot exchange rate $ 1.1000/€ 60-day forward rate $1.1050/€

US Dollar annual interest rate 2.4% Euro annual interest rate 0.84%

A) what is the annual effective US dollar interest rate from Euro investement?

B) Show the steps and calculate the amount of the covered interest arbitrage profit.

c) determine a theoretical 60-day forward rate (round to 4 decimal places) that will result in a zero covered interest arbitrage profit.

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