Current sport rate=$2 per BU Bundovian RFR= =3% One yr forward rate= 2.1 US RFR= 5% The maximum profit from covered interest rate arbitrage in the /BU market by borrowing $1000 or the BU equivalent is closest A. 19.05 B. 31.5 C. 72.5 pls help show your workings!
1000/2 = 500 500 * 1.03 =515 515*2.1 = 1081.5 1081.5 - (1000*1.05) = 31.5
you have to figure out that it’s cheaper to borrow dollars by setting up the IRP formula and isolating terms to compare borrowing rates. borrow cheap currency, convert at spot, lend at expensive currency, covert at forward and pay back cheap currency borrowed + interest to reap arb profit. 1000(1.05) = $1050 you need to pay back $1000 borrowed = $500 BU per the current spot ($2/BU). invest the 500 BU at 3% and collect 515 BU after one year. convert at forward to get $1081.5 (using 2.1/BU). pay back the 1050 and have profit of 31.5
wyantis - you mind explaining how you did that? your way looks alot cleaner then how i’ve been attempting this - just not sure if there some kind of rule as to what rates to use where and so forth.
the question tells u that there is arbitrage but doesn’t tell u which way, so set up the IRP forward / spot = (1+dc)/(1+fc) 2.1 / 2.0 = 1.05 / 1.03 1.05 > 1.0194 So basically you know that the forward rate is greater, which means in future you want to be holding BU, and at present you must do opposite of what you intend to do in future. So a) Start by borrowing $1000 USD & get in contract to buy $1000 in future. b) convert and invest BU at current spot rate = $500 c) After one year, collect BU interest = 515, and then convert back to USD. 515*2.1 = 1081.5 so arbitrage = 1081.5 - 1050 = 31.5 Also if the question asks, whats the effective interest rates its easy to calculate, is 81.5/1000 = .0815