Assume that the 180-day interest rate is 1% and 3%, respectively in
the U.S. and Japan. Also, the spot rate and 180-day forward rate are
equivalent at 120 yen per one U.S. dollar ($.008333 per one Japanese
yen). Discuss how you, as a trader for a commercial bank with
$1,000,000 to invest, could earn a risk-free return by engaging in
covered interest arbitrage? Be sure to show your calculations.  I need
at least 2 pages in length.

Hi,

First I will give you a few definitions of covered interest arbitrage:

1. ?Covered Interest Arbitrage:
A simple currency swap in which the counterparties exchange currencies
at both the spot and forward rates simultaneously. The forward swap
restores currency exposures to the original position without a
currency gain or loss-making this a way to adjust exposure to a
narrowing or widening of interest rate differentials rather than
adjusting currency exposures. Covered interest arbitrage also insures
interest rate parity because this relationship prevents speculators
from profiting by borrowing in a low interest rate country and
simultaneously lending in a high interest rate country and hedging the
currency risk."
Source: "IFCI Risk Institute"
http://risk.ifci.ch/00010949.htm

2. "Covered interest arbitrage is the transfer of liquid funds from
one monetary center (and currency) to another to take advantage of
higher rates of return or interest, while covering the transaction
with a forward currency hedge. Since the foreign currency is likely to
be at a forward discount, the investor loses on the foreign transfers
currency transaction per se. But if the positive interest differential
in favor of the foreign money center exceeds the forward discount on
the foreign currency (when both are expressed in percentage per year),
it pays to make the foreign investment."
Source: "Dr. Furfero's Website"
http://www.drfurfero.com/books/231book/ch07k.html

3. "Covered interest arbitrage: occurs when a portfolio Manager
invests dollars in an instrument denominated in a foreign Currency and
hedges the resulting foreign Exchange risk by selling the Proceeds of
the Investment forward for dollars."
Source: "MarketVolume.com"
http://www.marketvolume.com/glossary/c0515.asp

Now, let's get on with the calculations:

1,000,000 dollar x (1/120) = 120,000,000 yen.
120,000,000 x 1,03 (which is the interest rate in Japan) = 123,600,000 yen.
123,600,000 x (1/120) = 1,030,000 dollar.

Or, considering the fact that the spot rate and 180-day forward rate
stay the same, you could simply do:

1,000,000 dollar x 1,03 = 1,030,000 dollar

We are now going to calculate the profit one would receive from this investment:
1,030,000 - 1,000,000 = 30,000 dollar.
30,000 / 1,000,000 * 100 = 3 % proft.

Conclusion: it would be wise to go ahead with this investment because
the 3 % gained using covered interest arbitrage is more than the 1 %
the bank would receive in the US.


Search strategy:
Google: "covered interest arbitrage"

I hope you have enough information. As always, if you need any more:
please ask for a clarification!

Thank you,
paul_b_18

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Clarification of Answer by paul_b_18-ga on 09 Apr 2004 03:37 PDT

Hi,

Thanks for your kind words, your tip and the rating you gave me!
In the future, if you have any other general economics questions, I
would be happy to look into them!

Thank you,
paul_b_18

paul_b_18-ga, once again, thank you for the work you did on the
situation. The best deal about it is that did not take you long at all
to do this assignment. Thank you.

jara6650