Question

The spot rate between Canada and the U.S. is Can$1.2416/$, while the one-year forward rate is Can$1.2415/$. The risk-free rate in Canada is 4.43 percent and risk-free rate in the United States is 2.66 percent. How much in profit can you earn on $7,000 utilizing covered interest arbitrage? Multiple Choice

$123.31

$138.73

$108.93

$124.49

$99.59

Answer 1

We observe that interest rate of Canada is higher than US, hence Canada currency should depreciate over a period of 1 year. However, forward rates show that Can $ are stronger than $.

Hence arbitrage opportunity exists and we take following actions to enjoy the opportunity:

• Borrow $ 7000 @ 2.66%
• Sell $ 7000 @ 1.2416 we get (7000*1.2416) 8691.20 C$
• Invest this C$ @4.43%, we get (8691.20 * 1.0443) 9076.22
• Sell CS @ 1$ = 1.2415, we get (9076.22 / 1.2415) 7310.69
• Repay borrowed $ 7000 @ 2.66% i.e 7000 * 1.0266 = 7186.20
• Hence net gain = 7310.69-7186.20 = 124.49