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 Subject: Doing Business with Japan Category: Business and Money > Economics Asked by: jara6650-ga List Price: \$25.00 Posted: 08 Apr 2004 07:07 PDT Expires: 08 May 2004 07:07 PDT Question ID: 327115
 ```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``` 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```
 jara6650-ga rated this answer: and gave an additional tip of: \$5.00 ```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```