Question

Interest rate in US (Rh):	3.5%
Interest rate in Euro zone (Rh):	7.5%
Line of credit in US:	USD 10,000,000
Line of credit in in Euro zone:	EUR 8,000,000
The spot rate of EUR, now (SR0):	$1.25

Suppose your forecast tells you that the spot rate of EUR one year later (SR1) will be $1.20.
Then, your recommended investment strategy should earn a net profit of:

Answer 1

Here, we observe that there might be an arbitrage strategy available. We first borrow the Eur 8 million and convert into USD today to get = 8 x 1.25 = $10 million. Then we put this money on intrerest at the given US rate of 3.5%. We will get 1.035 x 10 = $10.35 million at the end of one year. We will have to pay interest on the Euros borrowed and the total amount will come out to be = 8 million x 1.075 = Eur 8.6 million. Now we go back to the dollars we had after one year and convert them to Euros at the then spot rate of 1.2. We will get = 10.35/1.2 = Eur 8.625 million. Hence, we will payback the Eur 8.6 million from this amount and keep the remaining = 8.625 - 8.6 = Eur 0.025 million = Eur 25,000. This will be our profit.