CIA Assume the following interest rate and exchange rate quotes. You can borrow
ID: 2809811 • Letter: C
Question
CIA Assume the following interest rate and exchange rate quotes. You can borrow S1,000,000 or its yen equivalent Y101,000,000: Spot exchange rate: 1-year forward rate: 1-year S interest rate: 1-year ^ interest rate: ¥101/S Y100/S 1.50% 0.70% Use the rule of thumb to identify whether coved interest arbitrage is worthwhile. If yes, what is your strategy and how much is your profit (show the steps)? What market forces would occur to eliminate any further possibilities of covered interest arbitrage?Explanation / Answer
Interest rate in United states is higher. This means investing in US will generate greater return. Therefore, borrow ¥101,000,000 at 0.70%. Amount to be repaid after a year = ¥101,000,000 x 1.007 = ¥101,707,000
Convert ¥101,000,000 to dollars by dividing by the $ spot exchange rate
¥101,000,000 / $101 = $1,000,000
Invest it at 1.5%. Total amount after a year becomes $1,000,000 x 1.015 = $1,015,000
Covert it to forward yen rate $1,015,000 x ¥100 = ¥101,500,000
Amount to be repaid after a year ¥101,707,000. This is more than the dollar return generated. Hence covered interest arbitrage is not possible.