A foreign exchange trader at J.P. Morgan Chase, can invest S5 million, or the fo

Question

A foreign exchange trader at J.P. Morgan Chase, can invest S5 million, or the foreign currency equivalent of the bank's shortterm funds, in a covered interest arbitrage with Denmark. Using the following quotes can the trader make covered interest arbitrage (CIA) profit. Valuc Arbitrage funds available Spot exchangc rate (DKR per S) 6-month forward rate (DKR per S) US dollar 6-month interest ratc Danish kroner 6-month interest rate A) Show if there is an arbitrage opportunity B) If your answer is yes in part A, show your arbitrage strategy and profit step by step. S5,000,000 7.0000 7.3500 2.000% 6.000%

Explanation / Answer

Forward rate= Danish Kroner per USD * (1+Interest rate in Sanish Krone)/(1+Interest rate in USA) Forward rate= =7*(1+0.06)/(1+0.02) Per USD                   7.2745 Since given forward rate is 73000, we can see that some arbitrage opportunity is available So the funds available are invested in Danish Krone Equivelent Danish Krone =5000000*7           35,000,000 This is invested in Danish Krone so amount after 6 months =35000000*(1+6%)           37,100,000 Amount converted back to USD =37100000/7.35             5,047,619 Amount payable in US after 6 months =5000000*(1+2%)             5,100,000 So this way there will be loss                 (52,381) Let's borrow in Danish Krone and invest in US =35000000*(1+6%)           37,100,000 Amount collected in US after 6 months =5000000*(1+2%)             5,100,000 amount converted back to Danish krone =5100000*7.35           37,485,000 Gain =37,485,000-37,100,000 Gain                 385,000

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