Question

You have the following market data. Spot price for the Swiss Franc is $1.179 per Franc. Two-month forward price is $1.22 per Franc. U.S. dollar LIBOR for two months is a continously compounded rate of 1.34% per annum. Swiss LIBOR for two months is a continuously compounded rate of 3.54% per annum. Underlying asset for this contract (i.e., the quantity of Swiss Francs to be delivered in two months) is 500,000 Swiss Francs. What is the total net profit if you execute the arbitrage strategy?

Answer 1

Theoretical forward rate,

F = S_oe^(rd-rf)t

Where rd = 1.34%, rf = 3.54%, t = 2/12 = 0.1667, So = 1.179

Forward Rate = F = $1.175

Here actual forward price higher than theoretical price.

So, Arbitrageur should buy 500000 swiss franc and short Swiss forward at $1.22 per franc.

In this process Arbitrageur will buy 500000 at spot price = 500000*1.179= $589,500

Short 500000 worth forward contract.

After two months he will close forward contract using 500000 francs which he purchased two months ago.

Income forward = 500000*1.22 = $610,000

Net Profit = 610,000-589,500

Net Profit = $20,500