Toshi Numata, FX analyst at Credit Suisse (Tokyo), observes that the ¥/$ spot ra
ID: 2614821 • Letter: T
Question
Toshi Numata, FX analyst at Credit Suisse (Tokyo), observes that the ¥/$ spot rate has been holding steady, and both U.S. dollar and yen interest rates have remained relatively fixed over the past few weeks. Toshi wonders if he should try an interest arbitrage strategy. Toshi's research associates — and their prediction models — are predicting the spot rate to move to ¥100.00/$ 90 days from today. Assume each year has 360 days and the interest rate for short loans is priced using the simple interest rate method.
Table 2. – Use for Questions a) to c)
Assumptions
Value
Arbitrage funds available (¥)
YEN 80,000,000
Equivalent arbitrage funds available ($)
USD 1,000,000
Spot rate (¥/$)
80.00
90-day forward rate (¥/$)
90.00
180-day forward rate (¥/$)
95.00
U.S. dollar LIBOR rate p.a. for the next 180 days
2.000%
Japanese yen LIBOR rate p.a. for the next 180 days
0.000%
a) Calculate the expected gain in $ from an Uncovered Interest Arbitrage (UIA) strategy using the expected spot rate in 90 days predicted by Toshi’s research associates.
b) The actual spot rate 90 days from today turned out to be72.00 (¥/$) instead of 100 (¥/$) as predicted. Discuss how Toshi’s interest arbitrage strategy in question a) is affected.
c) Discuss how a Covered Interest Arbitrage strategy is different from an Uncovered Interest Arbitrage strategy.
Assumptions
Value
Arbitrage funds available (¥)
YEN 80,000,000
Equivalent arbitrage funds available ($)
USD 1,000,000
Spot rate (¥/$)
80.00
90-day forward rate (¥/$)
90.00
180-day forward rate (¥/$)
95.00
U.S. dollar LIBOR rate p.a. for the next 180 days
2.000%
Japanese yen LIBOR rate p.a. for the next 180 days
0.000%
Explanation / Answer
Soln : a) In this case Japanese yen available : yen 80,000,000
He will Convert them in USD at spot rate to $1000000 and put them in bank for 90 days to receive the amount of 1000000*1.02*90/360 = $255000 as interest.
Expected Gains using the expected spot rate : 90 days =Yen 100/$
So, Net gain = 1255000*100 - 80000000 = Yen 45500000 = 45500000/100 = $455000
b) In case if actual spot rate = 72 Yen/$, the net gain/loss = 1255000*72-80000000 = 10360000
Value in $ = 10360000/72 = $143888.89
c) Now, if he covered the arbitrage with 90 day forward , In case if rate goes down to 72 Yen/$, but Toshi's actual gain using the forward will be = 1255000*90 - 80000000 = 32950000 , in $ = $457638.89
So, it is in worse condition will provide greater gain compare to uncvovered arbitrage strategy.