Question

15. If you engage in a covered interest arbitrage by investing in euro-denominated assets, what is your rate of return based on dollars? You must use the full formula for this calculation. A) 1.920% B) 2.000% C) 4.000% D) 4.250%

Answer questions 11 through 17 based on the following data: • 12-month interest rate on dollar-denominated assets (like US bank deposits) is 1.2% • 12-month interest rate on euro-denominated assets (EU’s bank deposits) is 4.0% • The current spot exchange rate is one euro for $1.50. • The current 12-month forward exchange rate is one euro for $1.47. • You expect the spot exchange rate might fall to one euro for $1.45 in a year, but you are not so sure.

Answer #1

Covered interest arbitrage by investing in euro-denominated assets

Rate of return based on dollars?

interest rate in USD : i(USD) = 1.2%

interest rate in EUR : i(EUR) = 4%

Spot rate EUR/USD : S(EUR/USD) = 1/1.5. i.e. 1 EUR is 1.5 USD

Forward rate EUR/USD : F(EUR/USD) = 1/1.47

Expected forward rate EUR/USD : E(F(EUR/USD)) = 1/1.45

Invest in forward, book the rate F(EUR/USD) = 1/1.47

As the question asks to invest in EUR denominated asset, take a position to convert 1 EUR in 1.47USD in one year.

Steps

1. Convert 1.5 USD to 1 EUR at spot rate

2. Invest 1 EUR at 4%

3. Receive the proceeds, i.e. 1.04 EUR after one year

4. Convert the proceeds to USD using the spot rate at that time (you locked the rate today i.e. 1/1.47). The proceeds will be 1.5288.

Rate of return is

investment of 1.5USD

return of 1.5288 USD

rate of return is 1.92%

Option A

How much arbitrage profit can you obtain with the following
information?
Hint. Covered interest arbitrage
Spot exchange rate: 1.1 Euro / dollar
Forward exchange rate: 1 Euro / dollar
Risk free rate in U.S: 3%
Risk free rate in Europe: 2%

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