Question

Consider the information below: U.S. investors have $1,700,000 to invest: 1-year deposit rate offered on U.S. dollars = 9.0% 1-year deposit rate offered on euros = 13.0% 1-year forward rate of euro = $1.20 Spot rate of euro = $.1.40 Given this information, if you conduct a covered interest arbitrage, how much dollars will you have in one year?

$1,819,000

None of the answers provided is correct

$2,768,571

$1,646,571

$3,227,280

Answer 1

Acc to IRPT,

Fwd rate = Spot rate * [ (1+Hi) / ( 1 + Fi) ]

Hi = Int rate in US
Fi = Int rate Europe

= $ 1.40 * [ 1+ 0.09 ] / [ 1 + 0.13 ]

= $ 1.40 * 1.09 / 1.13

= $ 1.35

Actual 1 Year Fwd Rate = $ 1.20

As IRPT fwd Rate and actual Fwd rate are not same, Covered int arbitrage exists.

Fwd Premium = [ Fwd Rate - Spot rate ] / [ Spot Rate ]

= [ (1/ 1.20) - ( 1 / 1.40) ] / ( 1 / 1.40 )

= [ 0.8333 - 0.7143 ] / 0.7143

= 0.1667 i.e 16.67%

Effective Rate in US = 9% + 16.67%

= 25.67%

Thus Invest in US only.

Maturity Value = Dep * ( 1 + r )

= $ 1700000 ( 1 + 0.09)

= $ 1700000 * 1.09

= $ 1853000

None of Answers are correct.

Pls do rate, if the answer is correct and comment, if any further assistance is required.