Question

A bank is quoting suppose the market condition is summarised as follows:

3 Months interest rates in US = 8%p.a

3 Months interest rate in Germany =5%p.a

Current spot rate Euros 0.80/$

3 months forward exchange rate Euros 0.7994/$

Required

Execute a CIA scheme, assuming an arbitrageur can borrow $ 1 Million or the equivalent of Euros 800,000

Answer 1

Hi,

General Inference:

USD\EUR = 0.8 (Spot) & EUR/USD = 1.25 (Spot)

USD\EUR = 0.7994 (Forward) & EUR/USD = 1.2501 (Forward)

• Interest rates are higher in US region when compared to Germany.
• From the exchange rates we can see that USD is in Forward discount and EUR is at forward premium.

Possible options:

A US investor invesing in Germany = (0.8/1.2501) * (1+0.05) = 6.71%

A German investor investing in United states = (0.7994/1.25) * (1+0.08) = 6.9%

From the perspective of a Arbitrageur:

1. Borrow 1 EUR @ 5% per annum
2. Convert to 1.25 USD
3. Sign a forward contract to purchase EUR
4. Invest for 3 months, 1.25 (1 + 0.08) = 1.35 USD
5. Deliver the forward contract signed before, 1.35/1.2501 = 1.08 EUR
6. Repay the loan (1+ 5%) = 1.05 EUR
7. Arbitrage profit = 1.08-1.05 = 0.03 or 3%

So if you borrow 800,000 Euros then arbitrage profit comes around 8,00,000 * 3% = EUR 24,000

Bala