Question

One year interest rates for identical investments in Japan and Canada are 7% and 2%, respectively. The current exchange rates for the two currencies are as follows: C$1.25/$, $.008/¥. Suppose the one year forward rate is ¥106.5/C$. Find the percentage return that can be earned via covered interest arbitrage, assuming that Japan is the domestic nation. Round intermediate steps and your final answer to four decimals and enter your answer in decimal format (EX: .XXXX)

Answer 1

The spot exchange rate = (1/0.008)*(1/1.25) = Yen 100/C$

Fair forward rate as per interest rate parity = 100*(1+0.07)/(1.02)

= Yen104.9020/C$

Since actual forward rate is different, arbitrage is possible.

Suppose 100 yen borrowed today and converted into 1 C$ at spot rate

Invested in C$ for one year and received = 1.02 C$

Convert back into JPY 1.02*106.5 = Yen 108.63

Repay Loan = 100(1.07) = 107

Arbitrage Profit = Yen 1.63

Hence, the percentage return that can be earned via covered interest arbitrage = 1.63*100/100 = 1.63%