Assume that annual interest rates are 5 percent in the United States and 4 perce
ID: 2790270 • Letter: A
Question
Assume that annual interest rates are 5 percent in the United States and 4 percent in Turkey. An FI can borrow (by issuing CDs) or lend (by purchasing CDs) at these rates. The spot rate is $0.6591/Turkish lira (TL).
If the forward rate is $0.6735/TL, how could the bank arbitrage using a sum of $4 million? What is the spread earned? (Do not round intermediate calculations. Round your answer to 4 decimal places. (e.g., 32.1616))
%
At what forward rate is this arbitrage eliminated? (Do not round intermediate calculations. Round your answer to 5 decimal places. (e.g., 32.16161))
Assume that annual interest rates are 5 percent in the United States and 4 percent in Turkey. An FI can borrow (by issuing CDs) or lend (by purchasing CDs) at these rates. The spot rate is $0.6591/Turkish lira (TL).
Explanation / Answer
a. Borrow $4,000,000 in USA by issuing CDs.
Interest and principal at year end = 4,000,000*1.05 = $4,200,000
Now make a loan in Turkey. Interest and principal = $4,200,000/0.6591*1.04 = 6,627,218.93 TL
Purchase US dollars at the forward rate. Amount = 6,627,218.93*0.6735 = $4,463,431.95
Profit = $4,463,431.95 - 4,200,000 = $263,431.95
Thus spread earned = 263,431.95/4,000,000 = 6.5858%
b. Forward rate = (1+rD USD)/(1+rL TL)*St
= [(1+0.05)*0.6591]/1.04
= $0.66544/TL