Question

A currency dealer can borrow $1,180,000 (or the equivalent in euros) for one year. The one-year interest rate is 4.80% in the U.S. and 9.40% in the euro zone. The spot exchange rate is $1.2548/€1.00 and the one-year forward exchange rate is $1.2162/€1.00. What arbitrage profit results if the trader borrows the maximum available funds?

Question 12 options:

	$18,211.10 OR €14,973.77
	$86,082.25 OR €70,779.68
	$11,979.02 OR €9,849.55
	$14,568.88 OR €11,979.02
	$73,574.57 OR €60,495.45
	$54,280.00 OR €44,630.82

Answer 1

Let us assume the dealer borrows $1,180,000 today in USD

The  $1,180,000 is converted into € at the spot exchange rate of $1.2548/€1.00 to get €940,388.91

This €940,388.91 is invested in Eurozone at 9.4% to receive €1,028,785.46 at the end of one year (940,388.91 + 9.4%)

€1,028,785.46 is converted back into USD at the end of one year at the one-year forward exchange rate of $1.2162/€1.00 to get $1,251,208.88

The original borrowed amount is $1,180,000 on which interest @ 4.8% has to be paid for one year. The amount to be repaid on the original borrowing today is ($1,180,000 + 4.8%) = $1,236,640.00

Arbitrage profit = $1,251,208.88 - $1,236,640.00 = $14,568.88

Arbitrage profit in € = Arbitrage profit in $ / forward exchange rate = $14,568.88 / 1.2162 = €11,979.02