An exchange dealer has $1 million for a short-term money market investment. That

Question

An exchange dealer has $1 million for a short-term money market investment. That is, he wants minimal risk in his investment, but he still wants to maximize the available return. Given the following market rates in the U.S. and London, what would you recommend? Why? And what is the annualized rate of return for your recommended investment?

Spot exchange rate

Explanation / Answer

Assumptions Value SFr. Equivalent Arbitrage funds available $1,000,000 SFr. 1,281,000 Spot exchange rate (SFr./$)                    1.2810 3-month forward rate (SFr./$)                    1.2740 U.S. dollar 3-month interest rate 4.800% Swiss franc3-month interest rate 3.200% Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency. Difference in interest rates ( i SFr. - i $) -1.600% Forward premium on the Swiss france 2.198% CIA profit 0.598% This tells should borrow U.S. dollars and invest in the lower yielding currency, the Swiss franc, and then sell the Swiss franc principal and interest forward three months locking in a CIA profit. U.S. dollar interest rate (3-month) START 4.800% END $1,000,000 ? ? 1.012000 ? ? $         1,012,000.00 ?             1,013,538.46 ? $                 1,538.46 ? ? ? ? ? ? Spot (SFr./$) ---------------> 90 days ----------------> F-90 (SFr./$) 1.2810 1.2740 ? ? ? ? ? ? SFr. 1,281,000.00 ? ? 1.0080000 ? ? SFr. 1,291,248.00 3.200% Swiss franc interest rate (3-month) Yes, should undertake the covered interest arbitrage transaction, as it would yield a risk-less profit (exchange rate risk is eliminated with the forward contract, but counterparty risk still exists if one of his counterparties failed to actually make good on their contractual commitments to deliver the forward or pay the interest) of $1,538.46 on each $1 million invested.

Related Questions

Navigate

• Browse (All)
• Browse A
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.