# Covered Interest Arbitrage

Hey guys, Couple days left and I think this is one area I am still struggling with (just from one angle). I understand cross-rate arbitrage perfectly but with covered interest, I have an issue. OK. So we calculate a FWD rate and compare it with what the market has priced it at. Scenario 1 : The FWD is overvalued. I understand what to do here as we have to buy spot, sell forward: a. At Year 0, borrow \$100. Will repay \$100 * (1 + US rate) in Year 1 b. At Year 0, use the 100 to convert to Euro at spot. c. See how much to place in a forward contract by calculating Euro \* (1 + EU rate) d. Enter into a FWD contract to sell Euro for at Year 1 for the amount calculated in c. e. In Year 1, convert to \$ as mentioned in d. above, pay back loan as in a., and make MONEY!! Scenario 2: FWD is undevalued. I know we now have to sell spot, and buy forward. BUT WTF ARE THE STEPS HERE??? Would appreciate some help guys!! You all rock.

Guys?? Any help?? Would appreciate it

Follow the steps above perhaps? Theres no better explanation that then that or whats in the book…

Justin, I meant for Scenario 2 where we calculate the FWD rate to be undervalued. We would buy the FWD contract and sell spot (opposite of Scenario 1) but was hoping somebody could take me through steps a. through e. similar to Scenario 1 (overvalued forward)

sorry, didn’t see that.

It’s cool. Hoping someone has a response.

> Scenario 2: FWD is undevalued. I know we now have > to sell spot, and buy forward. > > BUT WTF ARE THE STEPS HERE??? let’s say EURUSD forward is 1.25 and deemed undervalued. - call up your boy at Goldman and go long the forward - borrow EUR from some schmuck - sell EUR, buy USD on spot market - invest that USD in some nice “rf” treasuries At maturity: - collect USD rf interest \$\$ - buy EUR at specified forward price (1.25) - pay back the europeans before they start breaking your kneecaps - keep whatever’s left for the strippers after the exam govindmika Wrote: ------------------------------------------------------- > Hey guys, > > Couple days left and I think this is one area I am > still struggling with (just from one angle). I > understand cross-rate arbitrage perfectly but with > covered interest, I have an issue. > > OK. So we calculate a FWD rate and compare it with > what the market has priced it at. > > Scenario 1 : The FWD is overvalued. I understand > what to do here as we have to buy spot, sell > forward: > > a. At Year 0, borrow \$100. Will repay \$100 * (1 + > US rate) in Year 1 > b. At Year 0, use the 100 to convert to Euro at \> spot. \> c. See how much to place in a forward contract by \> calculating Euro \* (1 + EU rate) \> d. Enter into a FWD contract to sell Euro for at > Year 1 for the amount calculated in c. > e. In Year 1, convert to \$ as mentioned in d. > above, pay back loan as in a., and make MONEY!! > > Scenario 2: FWD is undevalued. I know we now have > to sell spot, and buy forward. > > BUT WTF ARE THE STEPS HERE??? > > Would appreciate some help guys!! You all rock.

Thanks man! That helps. Good luck Saturday!