The spot rate of exchange of Japanese yen for US dollars is currently 100 yen per dollar but the one year forward rate is 101 yen per dollar. Determine the yield on a one year zero coupon US government security if the corresponding yield on a Japanese government security is 2%.If the yield on a one-year zero-coupon US government security was higher than what you calculated, how would you exploit this arbitrage opportunity?
| Spot Exchange rate | 100 | yen/USD | |||
| 1 year Forward rate | 101 | yen/USD | |||
| Yield on Japanese Government Security | 2% | ||||
| Yield on US Government Security | = (100/101)*(1+0.02)-1 | = | 0.0099 | ||
| or 1% | |||||
| Yield on US Government Security based on Interest parity theory is 1% | |||||
| If the yield on US Security is higher than the 1%, Arbitrage Opportunity | |||||
| Borrow money in Japan and convert yen into USD at Spot rate of 100 yen/$ | |||||
| Invest in US Government Security for one year and after one year convert the USD at 101 yen/$ | |||||
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