Question

Assume that annual interest rates are 5 percent in the United States and 4 percent in Turkey. An FI can borrow (by issuing CDs) or lend (by purchasing CDs) at these rates. The spot rate is $0.6591/Turkish lira (TL). |

a. |
If the forward rate is $0.6735/TL, how could the bank arbitrage
using a sum of $4 million? What is the spread earned? |

Spread earned | % |

b. |
At what forward rate is this arbitrage eliminated? |

Forward rate | /TL |

Answer #1

Spot Rate = $0.6591/TL

As per IRPT,forward rate = Spot rate*(1+interest rate US)/(1+Interest rate Turkey)

= 0.6591(1.05)/(1.04)

= $0.6654/TL

a.Convert 4 million into TL at spot rate

= 4,000,000/0.6591

= TL 6,068,881.81

Invest and get = TL 6,068,881.81(1.04) = TL 6,311,637.08

Convert into dollar at forward rate = 6,311,637.08*0.6735 = $4,250,887.57

Pay back loan = 4,000,000*(1.05) = $4,200,000

Arbitrage Profit = $50,887.57

Spread Earned = 50,887.57/4,000,000 = 1.27%

b.Forward Rate = $0.6654/TL

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