An Italian currency dealer has good credit and can borrow €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 euro-denominated profit via covered interest arbitrage.

Question

Quizplus · Accepted Answer

Option C involves borrowing €800,000 at i_€ = 6%, translating to dollars at the spot, investing in the U.S. at i_$ = 2% for one year, and then translating €850,000 back into euro at the forward rate of $1.20 = €1.00. This would result in a net profit of €2,000. Option B would also result in a profit, but it is slightly less than option C. Option A is not a viable option as it involves trading $1,000,000 for €800,000 and investing at i_€ = 6%, which is not possible given the borrowing limit of €800,000. Therefore, option D is incorrect as it includes both option B and A.

An Italian Currency Dealer Has Good Credit and Can Borrow