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Suppose the annual interest rate is 2 percent in the US and 4 percent in Germany, the spot exchange rate is USD 1.60 / E...

Suppose the annual interest rate is 2 percent in the US and 4 percent in Germany, the spot exchange rate is USD 1.60 / EUR, and the 1­year forward rate is USD 1.58 / EUR. What is the arbitrage profit in USD at the end of the year if you start by borrowing USD 5,000,000?

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Answer #1

Borrow USD 5,000,000

Convert into EUR at spot rate and get 5,000,000/1.6 =EUR 3,125,000

Incest for one year and get 3,125,000(1+4%)

= EUR 3,250,000

Convert back into USD and get 3,250,000*1.58 = USD 5,135,000

Repay loan 5,000,000(1.02) =$5,100,000

Arbitrage profit =$35,000

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