Please show your work to understand the calculations. 1) A foreign exchange trad
ID: 2741125 • Letter: P
Question
Please show your work to understand the calculations.
1) A foreign exchange trader at J.P. Morgan Chase, can invest $10 million, or the foreign currency equivalent of the bank's short term funds, in a covered interest arbitrage with Denmark. Using the following quotes of exchange rate and annual interest rate, can he/she make covered interest arbitrage (CIA) profit?
$2,500.00
$5,000.00
Kr 9,599.99
Kr 681,600
2) Other things equal, and assuming efficient markets, if a Honda Accord costs $24,682 in the U.S., then at an exchange rate of $1.57/£, the Honda Accord should cost ________ in Great Britain.
£15,721
£10,795
£24,682
£38,751
Assumptions Value Arbitrage funds available $10,000,000 Spot exchange rate (kr/$) 6.1920 3-month forward rate (kr/$) 6.2350 Expected future spot rate (Kr/$) 6.2400 US dollar 3-month interest rate 3.000% Danish kroner 3-month interest rate 6.000%Explanation / Answer
1) Answer: Option (b) $5,000.
Calculations:
Interest rate differential = iKr = i$ = 6 -3 = 3%
Forward discount on the kroner = (6.1920 - 6.2350)/6.2350 = 0.043/6.2350 = -0.6897
Annualised rate = -0.6897*4 = -2.7588%
Covered Interest Rate Arbitrage potential = 3 - 2.7588 = 0.2412%
Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount invest in the higher interest yielding currency. If the difference in interest rates is less than the forward premium invest in the lower yielding currency.
Borrowings may be made in $ and invested in kroner.
Step 1: Borrow $10,000,000 for 3 months at 3/4%. Amount to be repaid = 1000000*(1.0075) = 10,075,000
Step 2: Convert $10,000,000 into Kr at the spot rate of 6.1920 to get Kr 61,920,000
Step 3. Invest Kr 61,920,000 for 3 months at 1.5%, giving a maturity value of 61920000*1.015 = 62,848,800
Step 4. Enter into a 3 months forward contract to sell 62,848,800 Kr for $ at 6.2350.
All these steps are entered into on day 1.
Step 5. After 3 months.
Get the proceeds of the deposit of Kr 62,848,800 and convert it into $ at the forward rate of 6.2350 to get $10,080,000
Step 6: Pay the loan of 10,007,500 and take the gain of $5000
2) Answer: Option (a) GBP 15,721.
Cost in GBP = 24682/1.57 = 15,721