Question

Problem: covered interest arbitrage

Borrowing rate US: 2% Borrowing rate Canada: 2.5%

Lending rate US: 1.5% Lending rate Canada: 2.25%

Spot CAN = 0.91$

1 month forward CAN: 0.89$

Show the 2 scenarios and their profit/loss. Start by borrowing 1000$ or 1000 CAN.

Answer 1

Scenario 1:

Borrow $1,000

Convert into Can $ at Spot Rate = 1,000/0.91 = Can$1,098.9011

Invest and get 1,098.9011*(1+0.0225) = Can $1,125.63

Convert back into $ at forward rate = 1,125.63*0.89 = $1,000.03

Repay Loan = 1,000*(1+0.02) = $1,020

Profit/(Loss) = $(19.97)

Scenario2:

Borrow Can $ 1,000

Convert into Dollar at Spot Rate = 1,000*0.91 = $910

Invest and Get 910*(1+0.015) = $923.65

Convert back into Can$ at forward rare = 923.65/0.89 = Can $1,037.81

Repay Loan = 1,000(1+0.025) = Can $1,025

Profit/(Loss) = $12.81