Question

Imagine visiting overseas, where you win the local lottery and can buy any foreign car you wish and will pay full retail price using the local currency, payable in three months. You have determined that you have enough cash at your bank in New York City, which pays 0.35 percent interest per month, compounding monthly, to pay for the car. There are two ways to pay for your car:

Keep the funds at your bank in the United States and buy a forward contract to pay for the car.

Buy a certain currency amount spot today and invest the amount in the foreign bank for three months so that the maturity value becomes equal to the price of the car.

Analyze the two alternatives presented and make a recommendation on purchasing the car. How could this purchase opportunity be considered arbitrage?

Be sure to provide calculations for your recommendation showing the best alternative.

What are the advantages of the alternative that you have selected?

Answer 1

1. Arbitrage opportunity arises when premium(forward rate - spot rate) percentage is less than the interest offered by the bank.

Interest percentage 0.35% per month

2. Case 1 - Entered into forward contract arbitrage opportunity arises

Spot rate 60, forward rate 61.2 for 3 months

Forward premium is 2% on spot rate. But interest amount offered is 1.05% for 3 months. In this situation better to take forward contract.

2. Arbitrage opportunity arises when the forward premium is less than the interest amount... Exactly opposite to the above scenario..

Advantage for the option selected is cost would reduce if the funds had not borrowed and Invested in foreign bank.