Question

10 points IS anies Changa foreign exchan of the banks 1 00 quotes short-term funds in cove r with the Euro. He has the follow Spot exchange rate €1.230/E 180-day forward rate €1.250/1 180-day euro interest rate 3.00% per year (1.5 for 10 days) 180 day pound interest rate 4.00 per year (2.0% for 10 days) early explain how James Chang can make a covered interest arbitrage prot 10 points 19. The United States runs a significant trade deficit with the rest of the world. Explain how this imbalance should be "corrected" under: c) A fixed rate regime? d) A floating rate regime?

Answer 1

18]

The steps to make a covered interest arbitrage profit are :

• Borrow €100,000,000 for 180 days
• Convert €100,000,000 into £ at the spot exchange rate. £ received = €100,000,000 / 1.230 =  £81,300,813.01
• Invest £81,300,813.01 at the pound interest rate for 180 days. £ received after 180 days = £81,300,813.01 * (1 + 2.0%) =  £82,926,829.27
• Enter into a forward contract now at the 180 day forward rate to convert £82,926,829.27 back into € after 180 days.   € received after 180 days = £82,926,829.27 * 1.250 = €103,658, 536.59
• Amount of € repay on original borrowing =  €100,000,000 * (1 + 1.5%) =  €101,500,000
• Arbitrage profit = € received after 180 days - amount of € repay on original borrowing
• Arbitrage profit = €103,658, 536.59 - €101,500,000 = €2,158,536.59