Arbitrage - Cash And Carry

CFA Level II Derivatives
#1

Hi guys,

I have been banging my head against the wall on this for literally hours and any feedback someone could provide would be more than appreciated.

Example 6 reading 48 spot rate swiss franc is $0.60, US interest rate is 6%, Swiss interest rate is 5%, futures contract expires in 78 days. If you caclulate the futures price it is $0.6012, the futures price quotes in the market is $0.62, and we are asked to execute an arbitrage transaction.

The futures price is too high so as I understand it we need to sell the futures, borrow risk free rate and buy the underlying.

My solution does not marry up with the text book solution so I was hoping someone could please tell me where my logic is wrong.

In caculating the return for dollar invested I think I should borrow Swiss Franc as it is cheaper at 5%, buy underlying at $0.60 — puting it to work at US risk free rate of 6.2%… And then sell the futures…

The textbook has a strange way of solving this question - I was wondering how people on here have managed to cacluate the solution to this one, because I’m getting nowhere… Thanks

#2

Any help or advice would be greatly appreicated, thanks guys

#3

The forward quote gives you too many USD for one CHF: $0.62 rather than $0.6012.

Because you would end up with too many USD, you start by borrowing USD.

I wrote an article on this that may be of some help: http://financialexamhelp123.com/covered-interest-rate-parity-irp-pricing-currency-forwards/

#4

Thanks so much for your reply, I have applied the theory to examples and questions and I can consistently see what needs to be done now. Those questions had seriously bothered me before reading your article, just my humble opinion but the readings make it more complicated than needed to be. Thanks again so much… I might be splitting hairs but why in the book when referring to dates if they say a period of 6 months for the year for example they use (180/360) as opposed to 0.5? Makes only a minor difference to the answer but seems strange. Thanks

#5

My pleasure.

#6

Because they are using the daycount convention to show you how it is calculated, in case in the future it isnt 180/360.