Question

1)Use the following information to answer the next two questions.

An investment banker in Spain notices that 1 year interest rates in Spain and Mexico are 12% and 8%, respectively. Current spot rates are as follows:

€1.02/$, $.15/MP. The one year forward rate is €.18/MP.What should the forward premium be for IRP to hold? a) .037 b) -.0357 c).04 d)-.04

2)Assuming that the banker has access to one million euros, find his covered interest arbitrage profit (in euros). Round intermediate steps to four decimals.

a)197700 b)201600 c)150600 d)0

Answer 1

Spot Rate = 1.02 * 0.15 = Euro 0.153 / MP

1. Forward Premium = (Forward Rate as per IRP - Spot Rate) / Spot Rate

Forward Premium = (0.153 * 1.12/1.08 - 0.153) / 0.153

Forward Premium = 0.037 Option A

2. Convert Euro into MP now at 0.153 / MP = 1000000 / 0.153 = 6535947.71 MP

Invest MP at 8% and realize = 6535947.71 * 1.08 = 7058823.529

Convert MP into Euro at Forward Rate = 7058823.53 * 0.18 = 1270588.235

Profit = 1270588.24 - 1000000 * 112%

Profit = $150600 Rounded Off Option C