Question

·Responses to the discussion questions to be between 150

and 250 words long. However, it is fine if your response is a little

longer. What is important is that your response should be clear and

comprehensive, and explain all key point

1. 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? (4 points)

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? (6 points)

Answer 1

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 (1.01) = $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