Question

The interest rate is in U.S. is 6% per year whereas the interest rate in Canada is 5% per year. Current spot rate C$1.3/$ and 6-month forward rate is C$1.26/$. Given the information covered arbitrage profit potential is 5.35%. In this case what is the trading strategy?

Answer 1

Following is the trading strategy :-

i) Borrow USD 76.92 at 6% for 6 months. Amount to be repaid after 6 months = 76.92 * (1.06) ^ (6/12) = USD 79.20

Convert USD 76.92 at the current spot rate to get = (76.92 * 1.30) = CAD 100

ii) Invest CAD 100 at 5% for 6 months. Amount to be repaid after 6 months = 100 * (1.05) ^ (6/12) = 102.47

ii) Convert CAD 102.47 into USD at the forward rate using the 6 month forward rate C$1.26 / USD, to yield = USD (102.47 / 1.26) = USD 81.32

Hence, arbitrage profit = USD (81.32 - 79.20) = USD 2.12