Question

How much arbitrage profit can you obtain with the following information? Hint. Covered interest arbitrage Spot...

How much arbitrage profit can you obtain with the following information?

Hint. Covered interest arbitrage

  • Spot exchange rate: 1.1 Euro / dollar
  • Forward exchange rate: 1 Euro / dollar
  • Risk free rate in U.S: 3%
  • Risk free rate in Europe: 2%
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Answer #1

For covered interest arbitrage let us borrow $ 100000 and sell at spot to obtain 100000*1.1 euros =Euros 110000

The amount is invested in Europe at 2%, inflow after year 1= Principal(1+ interest) =Euros 110000(1.02)=Euros 112,200

The euros are sold one year forward giving us 112200/1 dollars = $ 112200 (i.e. inflow)

Dollar bororowed =$ 100000

Amount payable after year 1 = Principal(1+ interest) = $ 100000(1.03) =$ 103000 (i.e. outflow)

Arbitrage profit =Inflow-Outflow =$ (112200-103000)= $ 9200 for every $ 100000 borrowed.

It is assumed the rates are one year forward and interest is mentioned for entire year.

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