Question

QUESTION 2

You are a French investor with access to €500,000.00. You are provided with the following quotations from a bank:

	Exchange rate	Borrowing interest rate	Investment interest rate
Spot rate (€/$	$1.4300 = €1.00	€ = 4.2% per annum	€ = 4.1% per annum
F360(€/$)	$1.4184 = €1.00	$ = 3.65% per annum	$ = 3.5% per annum

You have conducted your own calculations based on the above information and you identified an arbitrage opportunity. Therefore, you have now borrowed €500,000 and know you will have to repay it with interest at the end of one year  and you want to invest it in $ to make the arbitrage profit. What actions will you now take?

	a.	Enter into a long €521,000 forward, buy $715,000 with the €500,000, invest the $ at 3.50%. Buy the €521,000 one year from now in terms of the forward contract, repay the euro loan and make a profit of $1,038.60.
	b.	Enter into a short $740,025 forward, buy $715,000 with the €500,000, invest the $ at 3.50%. Sell the $740,025 one year from now in terms of the forward contract, repay the €521,000 and make a profit of $1,038.60
	c.	Enter into a long €521.732.23 forward, buy $715,000 with the €500,000, invest the $ at 3.50% and sell the $740,025 one year from now in terms of the forward contract, repay the euro loan and make a profit of €732.23.
	d.	Enter into a short $740,025 forward, buy $715,000 with the €500,000, invest the $ at 3.5% and sell the $740,025 one year from now in terms of the forward contract, repay the euro loan and make a profit of €732.23.

Answer 1

Following steps will be undertaken:

Enter into forward contract

Convert Euro to Dollars and get 500,000*1.43 = $715,000

Invest $ at 3.5%

Amount after one year = 715000*(1+3.5%) = $740,025

Convert into Euro at forward rate 740,025/1.4184 = Euro 521,732.23

Repay Loan 500,000*(1+4.2%) = Euro 521,000

Arbitrage gain = Euro 732.23

Hence, the answer is c. Enter into a long €521.732.23 forward, buy $715,000 with the €500,000, invest the $ at 3.50% and sell the $740,025 one year from now in terms of the forward contract, repay the euro loan and make a profit of €732.23.