Question

Interest rates on the U.S. dollar are 6.5% and euro rates are 5.5%. The dollar per euro spot rate is .950. What is the arbitrage profit on a required 1 million euro payment if the forward rate is .980 dollars per euro and the exchange occurs in one year?

Answer 1

Fair forward rate as per Interest Rate Parity = Spot Rate*(1+ Interest Rate Dollar)/(1+Interest rate Euro)

= 0.950*(1+0.065)/(1+0.055)

= $0.959/Euro

Since Actual forward rate is different, arbitrage is possible

Steps:

Borrow amount required for 1 million Euro payment today

Dollar required = [1,000,000/(1.055)]*0.950 = $900,473.93

Invest this amount in Euro and pay Euro 1,000,000 one year later

Repay loan on Dollar one year later = 9,00,473.93*(1.065) = $959,004.74

If converted one year later at forward rate, Dollar required = 1,000,000*0.980 = $980,000

Arbitrage profit = $20,995.26