c. An Italian currency dealer has good credit and can borrow €1,000,000 or $1,25
ID: 2740099 • Letter: C
Question
c. An Italian currency dealer has good credit and can borrow €1,000,000 or $1,250,000 for one year. The one-year interest rate in the U.S. is i$ = 3% and in the euro zone the one-year interest rate is i€ = 7%. The spot exchange rate is $1.25 = €1.00 and the one-year forward exchange rate is $1.22 = €1.00.
i. Show and explain (Prove) whether or not according to the information provided above there exist an arbitrage opportunity.
ii. If your answer to the above question is that “there exist an arbitrage opportunity”, Show and explain how to realize a riskless profit via covered interest arbitrage. To get full credit please show your work and make sure you indicate the currencies for each step. If your answer to the above question is that “IRP is holding so there is no arbitrage opportunity,” then just put “NA” to indicate that this question isn’t applicable.
Explanation / Answer
Spot rate Forward Rate Us $ Euro Us $ Euro 1.25 1 1.22 1 Interest Rate Mexico US 7.00% 3% As per interest rate parity, 1.25*(1.03) = 1*(1.07) 1.20 us $ = 1euro rates are different from forward rate i.e arbitrage opportunity exist. Arbitrageur would borrow 1250000 US $ at 3% and convert into 1000000 Euro at spot rate after that he will lend at 7% in Italy for 1 year after 1 year he would have 1070000 euro that he will convert at forward(Current rate) of 1.22 US $ / 1 Euro 1070000*1.22 US $ 1305400 US $ Amount to be paid for borrowing (1250000*1.03 = 1287500) His profit will be 1305400-1287500 = 17900 us $ or 14672.13 Euro
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