Question

Suppose that the current exchange rate is SF1.25/$ and three month forward exchange rate is SF1.30/$....

Suppose that the current exchange rate is SF1.25/$ and three month forward exchange rate is SF1.30/$. The three-month interest rate is 4 percent per annum in United States and 8 percent per annum in Switzerland. Assume that you can borrow up to $1,000,000 or SF 1,250,000.

a) Is Interest Rate Parity holding?

b) If your answer to part a is no, how would you realize a certain profit via a covered interest arbitrage? Also determine the size of the arbitrage profit.

Homework Answers

Answer #1

Answer:

Step 1) Borrow $1,000,000

Step 2) Convert to Swiss Franc at current spot rate of SF1.25/$, to get 1,000,000*1.25 = SF1,250,000

Step 3) Invest at 8% p.a. for three months, to get 1,250,000*(1+8%*3/12) = SF1,275,000

Step 4) Convert at the current spot rate (forward rate) of SF1.30/$, to get 1,275,000/1.3= $980,769.23

Step 5) Repay the dollar loan amount of 1,000,000*(1+4%*3/12) = $1,010,000

Step 6) Arbitrage profit = $ received after 3 months - $ repaid on loan

Arbitrage profit = $980,769.23 - $1,010,000 = - $33,730.77

Interest rate parity is a no-arbitrage condition. It is not holding in this case. There is an Arbitrage Loss of $33,730.77.

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