Question

Given the following information, find the profits you can make using covered interest arbitrage. Assume you can borrow either EUR 100,000 or JPY 14,619,883.04EUR interest rate = 3.5% per yearJPY interest rate = 0.4530% per yearS (EUR/JPY) = EUR 0.00684 per JPYF (EUR/JPY) = EUR 0.0074 per JPY for 1 year maturity forward contract.

a. Which currency would you borrow to conduct covered-interest arbitrage?

b. Assume you want your profits in euro, what covered-interest arbitrage profits do you expect in 1 year? Show all the steps involved in the covered-interest arbitrage process.

c. What would be the profits if you realize them in JPY? Show your calculations.

Answer 1

a. To conduct covered-interest arbitrage, we have to select the currency of country for which interest rate is high i.e., EUR.

b. Step 1. Borrow EUR 100000 at 3.50% and convert then into JPY at EUR 0.00684 per JPY. JPY in Hand 14619883.04 (100000 / 0.00684)

Step 2. Invest JPY14619883.04 at 0.4530% for 1 year. The Balance at the end of year JPY14686111.11

Step 3. Convert JPY Back to EUR at 0.0074 per JPY. EUR at Hand at the end of Year EUR 108677.22 (14686111.11 * 0.0074)

Step 4. Profit in Hand at paying off borrowed amount = 108677.22 - 103500 = EUR 5177.22

c. Profits in JPY = EUR Profits / Conversion Rate

Profits in JPY = 5177.22 / 0.0074

Profits in JPY = JPY699624.62