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
Source: "IFCI Risk Institute"
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"
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."
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.
Google: "covered interest arbitrage"
I hope you have enough information. As always, if you need any more:
please ask for a clarification!