Ms. Chambers, a U.S. arbitrageur, is looking for arbitrage opportunities after i
ID: 2755044 • Letter: M
Question
Ms. Chambers, a U.S. arbitrageur, is looking for arbitrage opportunities after interest rate changes. The available funds for arbitrage is $5,000,000. The spot exchange rate (Kr/USD) is 6.1720; 3 month forward rate (Kr/USD) 6.1980. Also US dollar denominated 3- month interest rate is 3.0% and Danish Kroner denominated 3-month interest rate is 6%.
Is arbitrage possible?
If arbitrage is possible, design the appropriate covered arbitrage strategy.
If arbitrage is possible, calculate the profits for the arbitrage strategy.
Explanation / Answer
Future spot rate = current spot rate*((1+risk free rate of quoted currency)/(1+ risk free rate of base currency))^corresponding period
= 6.1980*((1+0.06)/(1+0.03))^(3/12) = 6.2426
Arbitrage is possible as future spot rate <> forward rate
Arbitrage can be done converting 5,000,000 to Kr @ 6.1720 investing at 6% for 3 months in Kr and then converting back at forward rate of 6.1720 which can be locked in at current market today
Profit = 5000000*6.2426/6.1720 - 5000000 = 57193.77 USD
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