Question

Suppose that you are a foreign exchange trader for a bank based in New York. You are faced with the following market rates:

Arbitrage funds available                                                          $ 5,000,000

Spot exchange rate (kr/$)                                                          6.1717 (i.e., 1 dollar = 6.1717 krones)

3-month forward rate (kr/$)                                                       6.1981

U.S. dollar interest rate                                                             4.000 % per annum

Danish krone interest rate                                                          4.950 % per annum

Note:

• The maximum amount you may invest is $5,000,000 or its equivalent in Danish krones.
• Take 3 months to consist of 90 days and a year to consist of 360 days.

a) Is there a Covered Interest Arbitrage (CIA) opportunity here? Explain why or why not.

b) Given the data in part (a), spell out the actions you would take to profit from this situation. Your response should include step-by-step verbal explanations as well as detailed calculations.

• Which is the currency in which you would invest?
• What is the forward transaction you would engage in? Specify which currency you would sell forward and which currency you would buy forward.

What is the amount of arbitrage profits?

Answer 1

a.Fair forward Rate as per IRPT = 6.1717(1+0.04950*90/360)/(1+0.04*90/360)

= kr6.1862/Dollar

Since the actual forward rate is different from the fair forward rate, arbitrage opportunity exists.

b.Borrow Kr 5,000,000*6.1717 = Kr30,858,500

Convert into Dollar at spot rate and get $5,000,000

Invest and get 5,000,000 (1.04*90/360) = $5,050,000

Convert back into Kr = 5,050,000*6.1981 = kr31,300,405

Repay Loan = 30,858,500*(1+0.04950*90/360) = Kr31,240,373.94

Arbitrage profit = kr60,031.06

·Which is the currency in which you would invest?

Dollar

·What is the forward transaction you would engage in? Specify which

currency you would sell forward and which currency you would buy

forward.

Sell Dollar forward, buy krone

·What is the amount of arbitrage profits?

kr60,031.06