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Author Topic: Example Covered Interest Arbitrage  (Read 19386 times)

Offline Sara H.

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Example Covered Interest Arbitrage
« on: February 27, 2010, 03:50:18 pm »
Rf = 0.035
Rd = 0.06
F = 86.21 Yen/$
S = 88.95 Yen/$

Is dollar at a forward premium or a discount?
86.21 Yen/$ < 88.95 Yen/$ = discount

Does interest parity hold?

F/S = 86.21 Yen/$ / 88.95 Yen/$ = 0.97
(1+Rf) / (1+Rd) = 1.035 / 1.06 = 0.98

3.5 % interest in Japan is too high.
x / 1.06 = 86.21 Yen/$ / 88.95 Yen/$      x = 1.0273
Decrease to: 2.73 %

1.   Borrow at cheap US interest rate
Loan: 10,000,000 $ x 1.06 = 10,600,000 $

2.   Sell $ and buy Yen at spot market
10,000,000 $ x 88.95 Yen/$ = 889,500,000 Yen

3.   Loan in Tokyo
889,500,000 Yen x 1.035 = 920,632,500 Yen

4.   Cover your loan
10,600,000 $ x 86.21 Yen/$ = 913,826,000 Yen

5.   Profit
920,632,500 Yen - 913,826,000 Yen = 6,806,500 Yen