Question

Assume the following information:

Current spot rate of Australian dollar	=	$.86
Forecasted spot rate of Australian dollar 1 year from now	=	$.88
1-year forward rate of Australian dollar	=	$.93
Annual interest rate for Australian dollar deposit	=	4%
Annual interest rate in the U.S.	=	2%

What is your percentage return from covered interest arbitrage with $550,000 for one year?

Answer 1

Covered interest arbitrage is done as follows :

• Borrow $550,000 at the US interest rate for 1 year. Convert into A$ at the spot rate. A$ received = $550,000 / 0.86 = A$639,534.88
• Invest the A$ received at the Australia interest rate for 1 year. A$ received after 1 year = A$639,534.88 * (1 + 4%) = A$665,116.28
• Today, enter into a forward contract to convert A$ into $ after 1 year. After 1 year, exercise the contract. $ received =  A$665,116.28 * 0.93 = $618,558.14
• $ to repay on original borrowing = $550,000 * (1 + 2%) = $561,000
• Arbitrage profit = $ received after 1 year - $ to repay after 1 year
• Arbitrage profit = $618,558.14 - $561,000 = $57,558.14

% return = arbitrage profit / amount invested

% return = $57,558.14 / $550,000

% return = 10.47%