The one-year CD rates for financial institutions with AA ratings are 5 percent in the U.S.and 8 percent in France.An AA-rated U.S.financial institution can borrow by issuing CDs or lend by purchasing CDs at these rates in either market.The current spot rate is $0.20/Euro.

If the bank receives a quote of $0.1975/€ for one-year forward rates for the Euro (to buy and to sell),what is the arbitrage profit for the bank if it uses $1,000,000 as the notional amount?

Question

The one-year CD rates for financial institutions with AA ratings are 5 percent in the U.S.and 8 percent in France.An AA-rated U.S.financial institution can borrow by issuing CDs or lend by purchasing CDs at these rates in either market.The current spot rate is $0.20/Euro.

If the bank receives a quote of $0.1975/€ for one-year forward rates for the Euro (to buy and to sell),what is the arbitrage profit for the bank if it uses $1,000,000 as the notional amount?

Quizplus · Accepted Answer

Issue $1,000,000 in U.S. at 5%. Amount to repay at year-end: (1,000,000 * 0.05) = 1,050,000
 Purchase [$1,000,000 * (5€/$1)] = 5,000,000€ at 8%. Receive at year end 5,000,000€ * (1.08)
 5,400,000€
 Repatriate the 5,400,000€ at the one-year forward rate of $0.1975/1€ = $1,066,500
 
 Revenue - cost of funds = $1,066,500 - $1,050,000 = $16,500.

The One-Year CD Rates for Financial Institutions with AA Ratings