Question

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%

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 $.