Interest Rate Parity

The spot rate for the dollar is 0.1432 /ADF. Andorran and U.S. interest rates are 6.6% and 7.2%, respectively. If the 1-year forward rate is 0.1430 /ADF, a U.S. investor could earn an arbitrage dollar profit per ADF of: A) $0.0011. B) $0.0010. C) $0.0075. D) $0.0060.

A

B according to interest rate parity A if using continuous compounding, but cannt remember if interest rate parity requires continuous compounding

C. arb profit to us investor = 1+r_US - F/S * (1+r_AND) 1.072-0.143*1.066/.1432=$0.00748

agree with chrismaths

Dinesh… could you please post solution…

Rakesh posted the correct answer, But I had clicked on C for the same reasoning as chrismaths. sigh!! Answer is A

can someone post an explanation

Den dey is rong me sai.

fwd = S*exp(rf-rd) = .1432*exp(.072-.066) = .14406 Arb profit = .14406 - .1430 = .00106

0.1432*1.072/1.066 = 0.144006 0.144006 - 0.1430 = 0.001006 That should be B.

I am at work, but as far as I remember, they took some notional $1 and moved it all over the place to manage to figure out that the answer was A

I still don’t get it.

ok, wait… have a 11 o clock, will type in at arnd 11.30

Just spotted it said “arbitrage dollar profit per ADF”. I misread it as profit per dollar. So the answer is 0.00748882682*.143 = 0.001071 ~= .0011 (A).

  1. Borrow ADF, convert to USD spot, invest dollar After 1 year the payout is = .1432 * 1.072 = .15351 2) To cover ADF exposure on the forward date, you enter into a forward contract to buy 1.066 ADF(you borrowed 1 ADF, so you owe 1.066 ADF on the forward date) and sell 1.066 \* .1430 = .152438 You realize a arbitrage profit of (1) - (2) = ~0.0011 on the forward date.

I do not understand why the answer isn’t D. .1432(1.066/1.072) = .1424 .1430-.1424 = .0006 I read the section, think I get it, then come here and get bitchslapped.

Smarshy Wrote: ------------------------------------------------------- > I do not understand why the answer isn’t D. > > .1432(1.066/1.072) = .1424 It’s 0.1432 * 1.072/1.066 to get the appropriate fwd rate. > .1430-.1424 = .0006 Even after you get the correct fwd rate, you can’t just take the difference between fwd and spot to get the arbitrage profit because they settle on different dates and thus need the time-value adjustment. > > I read the section, think I get it, then come here > and get bitchslapped.

chrismaths Wrote: ------------------------------------------------------- > Just spotted it said “arbitrage dollar profit per > ADF”. I misread it as profit per dollar. > > So the answer is 0.00748882682*.143 = 0.001071 ~= > .0011 (A). yep perfect… I had the same problem

I don’t get your calc 1.072-0.143*1.066/.1432 You are multiplying the future rate 0.143 with the interest rate and then divide it by the spot rate?