Question

# A foreign exchange trader at EXIM Bank can invest \$100000, or the foreign currency equivalent of...

A foreign exchange trader at EXIM Bank can invest \$100000, or the foreign currency equivalent of the bank's short term funds, in a covered interest arbitrage with india. Using the following quotes, can the trader make covered interest arbitrage (CIA) profit?

Arrbitrage funds available \$100,000

Spot exchange rate rs/\$ is 73

3 month forward rate rs/\$ is 75

US dollar 3-month interest rate 4%

Danish kroner 3 month interest rate 6%

#### Homework Answers

Answer #1

Facts

Spot -\$1=Rs 73

3 Month Forward \$1= Rs 75

US Interest Rate = 4%( 3 Month)

India Interest Rate = 6%  (3 Month)

Funds available =\$ 100000

Workings

1. Calculation of Forwards Rate as per IRPT (Interest Rate Parity Theory)

Spot \$1 = Rs 73

after 3 months

\$1 will become \$1*(1.04) and Rs 73 become Rs 73*(1.06)

\$1*(1.04)=Rs 73*(1.06)

solving above equation \$1=73*(1.06)/(1.04)

\$1=Rs 74.40

If IRPT holds good the Forward Rate should have been \$1= Rs 74.40 but actually the Forward Rate is \$1 = Rs 75.

Therefore IRPT does not hold good. If IRPT is absent Arbitrage exist. The trader can make CIA profit.

Strategy:

Since the in Forward market the \$ is over priced Forward Sell \$. Hence spot Buy \$.

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