use up to four decimal places One month after the events described in the previo
ID: 2646343 • Letter: U
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use up to four decimal places
One month after the events described in the previous two questions, Luis Pinzon once again has S1 million (or its Swiss franc equivalent) to invest for three months. He now faces the following rates. Should he again enter into a covered interest arbitrage (CIA) investment? 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. This tells Luis Pinzon he should borrow U.S. dollars and invest in the lower yielding currency, the Swiss franc, and then sell the Swiss franc 'principal plus interest' forward three months, hence locking in a CIA profit.Explanation / Answer
Difference in Interest Rate =
US Dollar Interest Rate for Three Months = 4.750 / 4 = 1.1875%
Swiss Franc Interest Rate For Three Months = 3.625 / 4 = 0.90625%
Difference in Interest Rate = 0.28125%
Difference in Exchange Rate after Three Months = 1.3392 - 1.3286 = 0.0106 /1.3392 = 0.79151%
Difference in Exchange Rate is greater than difference in Interest Rate so investment should be made in Franc.
Step 1. Borrow Dollars= 1,000,000 at 1.1875% Interest Rate for 3 Months
Step 2. Convert Dollars in Franc to get $1,000,000 x 1.3392 = 1,339,200 at Spot Rate
Step 3. Invest in Franc For 3 Months at 0.90625%
Step 4. After 3 Months investment value will be: 1,339,200 x 0.90625% + 1,339,200 = $1,351,336.50
Step 5. Convert Franc in US Dollars: 1,351,336.50 /1.3286 = 1,017,113.13
Step 6. Calculation of 3 Months Interest on US Dollars Loan = 1,000,000 x 1.1875% = 11,875
Step 7. Calculate Total Loan Amount including Interest = 1,011,875
Step8. Calculation of Arbritage Gain: 1,017,113.13 - 1,011,875 = $5,238.13
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