A currency dealer has good credit and can borrow either $1,000,000 or €800,000 for one year.The one-year interest rate in the U.S.is i_$ = 2% and in the euro zone the one-year interest rate is i_€ = 6%.The spot exchange rate is $1.25 = €1.00 and the one-year forward exchange rate is $1.20 = €1.00.Show how to realize a certain profit via covered interest arbitrage. A)Borrow $1,000,000 at 2%.Trade $1,000,000 for €800,000; invest at i_€ = 6%; translate proceeds back at forward rate of $1.20 = €1.00,gross proceeds = $1,017,600. B)Borrow €800,000 at i_€ = 6%; translate to dollars at the spot,invest in the U.S.at i_$ = 2% for one year; translate €848,000 back into euro at the forward rate of $1.20 = €1.00.Net profit $2,400. C)Borrow €800,000 at i_€ = 6%; translate to dollars at the spot,invest in the U.S.at i_$ = 2% for one year; translate €850,000 back into euro at the forward rate of $1.20 = €1.00.Net profit €2,000. D)Borrow €800,000 at i_€ = 6%; translate to dollars at the spot,invest in the U.S.at i_$ = 2% for one year; translate €848,000 back into euro at the forward rate of $1.20 = €1.00.Net profit is $2,400.Additionally,one may borrow €800,000 at i_€ = 6%; translate to dollars at the spot,invest in the U.S.at i_$ = 2% for one year; translate €850,000 back into euro at the forward rate of $1.20 = €1.00.Net profit is €2,000.

Question

Quizplus · Accepted Answer

Option D provides two ways to generate profit. Firstly, borrowing €800,000 at i_€ = 6% and investing in the U.S. at i_$ = 2% for one year will yield a profit of $2,400 when the euro is converted back to dollars at a forward rate of $1.20 = €1.00. Additionally, one can borrow €800,000 at i_€ = 6%, invest in the U.S. at i_$ = 2% for one year, and convert back €850,000 into euro at the forward rate of $1.20 = €1.00 to make a profit of €2,000. Therefore, option D provides the best choice for covered interest arbitrage.

A Currency Dealer Has Good Credit and Can Borrow Either