Question

1. Assume the following information:

Spot rate of Canadian dollar = $.80

90-day forward rate of Canadian dollar = $.79

90-day Canadian interest rate = 4%

90-day US interest rate = 2.5%

1. Explain the steps you would use in covered interest arbitrage with $1 million of your own money (no leverage used).

2. What would be your profit?

Answer 1

Forward Rate as per Interest Rate Parity theory,

= Spot Rate × [(1+Interest Rate in US)/(1+Interest Rate in Canada)]

(assumed 360 days in a year)

= 0.8 × [{1+(0.025*3/12)}/{1+(0.04*3/12)}] = 0.797

Actual Forward Rate < Theoretical Forward Rate. Therefore, Canadian Dollars forward rate is undervalued.

To make an Arbitrage Gain, Sell Canadian Dollar Spot & Buy Canadian Dollar Forward.

Therefore, it is Not Possible to make an Arbitrage Gain, by using only own$1,000,000. Because we have to buy USD by selling Can$, but we already have USD and Borrowing is not allowed. Therefore, it is not possible to sell Can$ and buy $ now. So, Arbitrage is not possible.